2014 Contrarian Investment Ideas (But Beware Of Falling Knives)

Posted by Bigtrends on December 27, 2013 10:37 AM

2014 Contrarian Investment Ideas (But Beware Of Falling Knives)
The 2014 Contrarian Investment Tour, From Rupees to Copper

Don't try to catch a falling knife. It's one of the oldest saws on Wall Street.  But to make a lot of money, sometimes you have to get a little bloody.

So say contrarians like Brian Singer.  The risk is great, "but the return is of such an astounding magnitude, you're willing to do it," says Singer, manager of the William Blair Macro Allocation Fund (WMCNX).

This might seem a tough time for investing iconoclasts seeking undervalued assets.  The stock market is rallying, many bonds still aren't cheap and the fact that interest rates may rise further as the economy recovers will keep pressure on bond prices.  Yet money managers who buy when everyone else sells see plenty of opportunities.

Singer, for one, recently put 19 percent of his $355 million fund in the Indian rupee, which has lost 30 percent of its value in the past two years.  Others are betting on fallen emerging market (EEM) stocks, industrial mining companies and closed-end municipal bond funds.  For investors fearful that the U.S. stock market is overvalued, contrarian funds can be a hedge of sorts -- albeit a potentially volatile one.

Commodity Bets

Other contrarians have won with bets on equally offbeat sectors. The Hodges Pure Contrarian Fund (HDPCX) is up 42.3 percent in the past year, besting 95 percent of its small-cap fund peers. In 2013, fund co-manager Don Hodges says, he more than doubled his money on airline stocks after their prices tumbled.  Now he's betting on coal (KOL), iron and copper (JJC) mining stocks like Cliff Natural Resources Inc. (CLF) and Freeport-McMoRan Copper & Gold Inc. (FCX).  He says a recovery in the sector will begin when the Chinese work off their commodity inventories and begin buying again.

The Hodges fund's commodity bets highlight one of the risks of contrarian investing. Out-of-favor sectors tend to be cyclical ones, prone to booms and busts, which can make some contrarian strategies volatile. 

To mitigate volatility, contrarians must diversify. Singer says currencies do that for him because they behave very differently from stocks and bonds.  In the rupee's case, interest rates are so high in India that he's getting a 6 percent yield on the equivalent of a bank deposit.  While he uses financial derivatives to get his rupee exposure, individual investors can buy currency certificates of deposit.  A three-month FDIC-insured rupee CD from Everbank yields 7.25 percent.

Singer says the rupee is undervalued by as much as 70 percent.  Like most contrarians, he isn't buying just because the currency has fallen, but because he sees a catalyst for a recovery . In this case, the August appointment of Raghuram Rajan as India's central bank governor was crucial -- Rajan has already taken actions to stabilize the currency by raising interest rates.

Emerging Markets

A somewhat tamer contrarian approach in 2014 would be to invest in a diversified emerging markets fund. The BRIC nations -- Brazil (EWZ), Russia (RSX), India (EPI) and China (FXI) -- have all taken their lumps this year.  "Emerging market stocks are selling at a tremendous discount to U.S. ones," says Jason Hsu, chief investment officer of Research Affiliates, which oversees some $57 billion in a contrarian style for Pimco Funds.

As evidence, Hsu points to the Shiller price/earnings ratio, which measures the price of stocks or a stock index against their inflation-adjusted earnings over the past 10 years.  It is meant to eliminate some of the valuation distortions caused by temporarily inflated or depressed earnings.  Currently the S&P 500 (SPX) (SPY) has a Shiller p/e of 24, significantly above its 16.5 average.  Emerging markets have a ratio of 13.5, says Hsu.  The value-oriented PowerShares FTSE RAFI Emerging Markets ETF (PXH), which Research Affiliates designed, has 55 percent of its portfolio in BRICs.

A number of bond sectors have also had a rough 2013 and may be due for a comeback.  The average municipal bond fund is down 3.4 percent this year, according to Bloomberg data.  But that's nothing compared to the shellacking some closed-end municipal bond funds have taken.

Closed-end funds sell a fixed amount of shares to raise money for investments and then trade on an exchange like stocks. They can trade at a price that's higher or lower than the value of their holdings.  During times of distress they can trade at deep discounts.  Shares of the BlackRock Municipal Target Term Trust (BTT) have fallen 30 percent in the past year and now trade at an 11.5 percent discount to portfolio value.   Since bond yields move inversely to their prices, the BlackRock fund yields 6.73 percent on a tax-free basis.  That's the equivalent of 10.35 percent on a tax-adjusted basis for those in the highest income brackets.

Bullion Brushoff

Treasury Inflation-Protected Securities, or TIPS, are also starting to look attractive after a selloff this year, say some managers.  "It's been a long time since we've seen TIPS at this low a price," says Hsu.  The principal value of the securities adjusts periodically to the change in the consumer price index, and they pay a fixed rate of interest lower than the interest paid to a holder of conventional debt.

Until this year, many TIPS had negative yields as investors, afraid of the potential inflationary effects of U.S. monetary policy, drove bond prices up and yields down.  Now some of those fears have abated and TIPS with maturities of more than 20 years are yielding 1.5 percent over inflation.  While performance chasers are leaving the sector for stocks, Hsu has begun building a position.

Not every beaten-up sector is attractive to contrarians.  The price of gold (GLD) has fallen 25 percent this year to $1,246 an ounce.  Gold mining stocks (GDX) are down 50 percent.  Manager Rudolph Riad-Younes of RSQ International Equity Fund (RSQVX) isn't interested.  He says the price of gold historically has traded between 10 percent to 15 percent above its cost of production, but today it is closer to 20 percent.  Worse, Riad-Younes expects the cost of producing gold to decline in the next five years, further driving down prices.

If there's nothing appealing to buy, contrarians can, and do, play the other side of the field by shorting, or betting against, securities.  his is inherently dangerous as markets have been trending higher. So managers such as Singer and Hsu balance their short positions with long bets that anticipate improved performance.

Hsu is betting on a decline in large U.S. stocks as well as on improved prospects for high-yield and emerging market bonds.  Singer is short the iShares Russell 1000 Growth ETF (IWF) while long the iShares Russell 1000 Value ETF (IWD).  "People are saying the U.S. is the only source of growth and stability in the world," says Singer.  "We think they're going to be surprised next year at how volatile growth stocks can be."

Spoken like a true contrarian.

Courtesy of Lewis Braham, Bloomberg.com

 

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