As the market keeps suffering losses, several renowned investors have tried to shed some light regarding the direction a true investor must take, such as Howard Marks (Trades, Portfolio) with his most recent memo, "What Does The Market Know?" In times of turbulence, I find it refreshing to re-read some of these investors, and while bear markets are usually when a value investor prefers to enter positions, Seth Klarman (Trades, Portfolio) provides a warning on being contrarian just for the sake of it in his book, "Margin of Safety."
"Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular securities almost never are. If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price will fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued."
Let's think about the energy and oil sector: Right now, the whole sector is thought of as inappropriate and risky. However, as value investors we must always remember that risk is not volatility, as modern finance theory states, but rather, it is the probability and magnitude of a potential loss. With prices being so low, the risk is actually decreasing, not increasing with lower and lower prices.
"Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to be against the crowd with the odds skewed in their favor."
This message is very important: Stocks do not operate in a vacuum and, as Klarman stated: "Sometimes being too early is indistinguishable from being wrong." On the first point, we must remember that the perception of investors is what will eventually drive stocks higher or lower, but they depend on the market view on the sector and the economic fundamentals. I believe that while some positions can be entered now with low probabilities of losses, it is futile to think that the market/sector will turn around in a couple of months. The creation of a wide margin of safety and patience are the best friends of a value investor at these times. Just as Howard Marks (Trades, Portfolio) mentioned in his memo, "proceed, but with caution."
