In chapter two of "The New Buffettology," authors Mary Buffett and David Clark looked more deeply into the concept of a “selective contrarian investment strategy.”
A plain contrarian is an investor interested in stocks with falling prices. Like Warren Buffett (Trades, Portfolio), they are buying when mainstream investors are selling; it’s a standard part of value investing. The authors say this strategy emerged from the research of Eugene Fama and Kenneth French (also known as Fama and French); they discovered that stocks that had been undervalued in the previous two years could generate above-average returns in the following two years.
Buffett, though, sees a falling price and lack of popularity as only a starting point. He insists the company must have “exceptional” business economics, as well as a contrarian price.
As pointed out in chapter one, contrarian prices arise out of shortsightedness among 95% of all investors; because of these shortsighted perspectives, bad news embedded in the daily noise can be enough to scare investors out of their low-conviction holdings:
“Warren is the ultimate exploiter of the foolishness that results from other investors’ pessimism and shortsightedness. You see, most people and financial institutions (like mutual funds) play the stock market in search of quick profits. They want the fast buck, the easy dollar, and as a result they have developed investment methods and philosophies that are controlled by shortsightedness.”
In addition to a contrarian price and exceptional business case, Buffett also demands that target companies have a “durable” competitive advantage. In other words, the company needs to have price protection of some kind; examples include proprietary technology, such as Apple (AAPL, Financial), and strong brands, such as Walmart (WMT, Financial).
There is one more explanatory thread: Buffett looks at potential buys as a private business person would. He approaches a potential acquisition as a business analyst, not a securities analyst. The authors list some of his successes:
- H&R Block (HRB, Financial): Buffett bought 8% of the company in 2000, at the depressed price of $28 per share. By 2002, the shares were trading at around $60 per share.
- Washington Post Co.: In 1974, he bought 1.7 million shares at about $6 per share; in 2002, shares were worth about $500 each—an average compounding rate of 17.8%.
As to why such bargains appeared, the authors reported, “Warren found that no matter how intelligent most people are, the nature of the beast ultimately controls their investment decisions.” For the psychological reasons behind the “beast,” see our review of James Montier’s book, “The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy.”
Part of that short-term perspective is systemic: authors Buffett and Clark said mutual fund managers are under intense pressure to deliver the highest annual returns possible because mutual funds are marketed to people who only want to buy funds with top performance ratings. They added, “The nature of the mutual fund beast influences a lot of smart people into playing a short-term game with billions in capital. No matter what a fund manager’s personal convictions may be, producing the best short-term results possible is the way to keep the job.”
Further, when market players with short-term perspectives (including fund managers who need to aim for the highest quarterly and annual returns) hear bad news, they sell. “To make the big bucks in the short-term game the investor has to be one of the first to get in on the stock before it moves up, and one of the first to get out before it moves down.”
This business of selling shares after bad news is known as the “bad-news phenomenon.” For Buffett, it is known as the gift that keeps on giving. Fortunately for the guru and other value investors, the bad news never stops, providing ongoing opportunities for those with patience and discipline.
When he was starting out, Buffett was a student and employee of Benjamin Graham, the father of modern value investing. One of the teaching tools used by Graham was Mr. Market, who remains reasonably well known in investing circles.
Mr. Market is the partner of everyone who invests through a stock market. As the authors describe him, he has an interesting personality trait: some days he is wildly optimistic and other days he is deeply pessimistic about businesses and the future.
Every day, he offers to buy you out or to sell you even more shares. On his sunny days he will ask for a higher price, and on dark days will offer lower prices. But whether he is having a good or bad day, he will come to work every day and make offers to you.
Graham taught Buffett that he should buy when Mr. Market was gloomy because, on those days, he would get the best prices. And, the authors reported, Graham offered one more “twist”: Mr. Market was there to benefit him, not guide him. Look at the prices Mr. Market offers, but ignore his opinions on what businesses are worth.
According to the authors, “Warren says that, to this day, he still likes to imagine himself being in business with Mr. Market. To his delight he has found that Mr. Market still has his eye on the short term and is still manic-depressive about what businesses are worth.”
Finally, and foreshadowing what’s to come in a future chapter, the authors said, “He figured out that some, but not all, companies have what he calls a 'durable competitive advantage' that creates an economic engine powerful enough to pull these companies’ stock price out of almost any kind of bad-news mud that the shortsighted stock market can get them stuck in.”
The authors
Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor”.
This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
