The case for contrarian investing

The worse the market sentiment, the better the profit opportunities and, right now, UK equities may represent “the trade of the decade”. Cormac Lucey explains why

Diversity is regarded as an unambiguously good thing nowadays. Imagine the reaction you might get if you were to try to assert the contrary among your family or in your social group. But, for all that diversity is pushed and advocated, it can also sometimes be woefully lacking in our public discourse. 

More than eyebrows may be raised if somebody states their support for Donald Trump or the UK’s decision to exit the European Union. But, in 2016, millions of sensible people voted for Trump and for Brexit. 

Is it not odd that today their viewpoint is so universally dismissed?

While being contrary is generally regarded as a negative social habit, it can pay rich dividends from an investment perspective: the worse the market sentiment is, the better the profit opportunities. 

This is the credo of contrarian investing. Nathan Rothschild, a 19th-century British financier and member of the Rothschild banking family, is credited with saying that “the time to buy is when there’s blood in the streets”. 

Brexit is widely regarded by “right-thinking people” as a self-inflicted wound. A June 2022 analysis by John Springford for the European Centre for Reform concluded that the UK economy had substantially underperformed post-Brexit compared to how it might have fared if the British public had not voted to leave the EU. 

UK gross domestic product was 5.2 percent lower than it would have been if the UK had remained in the EU; investment was 13.7 percent lower; and goods trade was down 13.6 percent. 

Since then, Boris Johnson has given way as Prime Minister to Liz Truss, and she has been replaced by Rishi Sunak. And there was that snap financial crisis triggered by Kwasi Kwarteng’s mini-budget. 

The UK has seldom looked so bad. 

There isn’t exactly blood running on the streets, but it is pretty bombed out as a popular investment destination. That’s one reason why Rob Arnott, Chair of Research Affiliates, has argued that UK equities represent “the trade of the decade”. He states that “UK equities offer one of the most attractive risk-return trade-offs, priced to earn a return a notch higher than emerging market equities with significantly lower volatility”. 

In essence, Arnott follows the Warren Buffett dictum about the equities market: “in the short-term, the market is a popularity contest; in the long-term, it is a weighing machine”. 

As investor holding periods stretch out beyond five years, realised investor returns increasingly become a function of the price paid. So, while very expensive stocks can become even more expensive over a few years, as more time passes, they will increasingly struggle to generate strong returns. 

Conversely, if you buy a deeply discounted asset (such as UK value stocks today), they may not initially show a great return but, over time, they should. In fact, with an asset this deeply discounted, there’s every chance it will outperform even in the short-term. 

Arnott wrote his piece in early 2021 when he argued that, among the major equity markets, UK stocks were trading in the cheapest quintile of their historical norms based on both price-to-book and price-to-five-year average cash-flow ratios and in the bottom third, based on price-to-five-year average sales ratio. His previous big call—to invest in emerging market value stocks in 2016—generated returns of 80 percent in its first two years.

Since announcing this trade of the decade, UK value stocks have risen by over 20 percent while the S&P index is marginally lower than it was, and the Nasdaq has dropped by over 20 percent. 

Sometimes diversity of thought isn’t so bad after all.