Two years ago, John Paulson, head of the eponymous hedge fund Paulson & Co, racked up $15 billion in gains on a spectacularly successful bet against the housing market. Mr. Paulson's eye-popping performance was estimated to enrich his bank account by an estimated $3 billion to $4 billion, according to the Wall Street Journal.
Last week, we learned that David Tepper, head of Appaloosa Management, will realize a somewhat less remunerative, though equally eye-popping, payday estimated at $2.5 billion by betting that beaten-down banking stocks wouldn't remain beaten down into perpetuity.
Contrarians or not?
Messrs. Paulson and Tepper have been referred to as contrarian investors, which begs the question: What's a contrarian investor?
The answer isn't as straightforward as you might think. It often conjures Associate Justice Potter Stewart's pithy riposte when asked to define pornography: "I shall not today attempt further to define the kinds of material but I know it when I see it."
For some, contrarian investing is simply a matter of investing against the crowd, as measured in the tenor of media reports or the sentiment of institutional-investor polling. Other investors believe contrarian investing can be divined in certain numerical measures like P/E multiples or price-to-book and price-to-sales ratios.
I prefer the former concept of contrarian investing to the latter, because the latter implies that contrarian investing is synonymous with value investing. But value investing based simply on low multiples and ratios isn't always contrarian, especially when analyzing cyclical companies. For example, shares of Ford Motor Company (NYSE:F) traded up in the $30s in 1999, while sporting a P/E that was as low as three and as high 13. Four years later, in 2003, the price ranged between $6 and $16, while the P/E multiple that averaged 27.
True Contrarians
I see contrarians like John Paulson and David Tepper being more grounded in sentiment and, just as important, price, than in simple measures of value.
To wit, the Dow Jones U.S. Home Construction Index had quintupled from 2001 through 2005. Despite the unprecedented rise, many investors still believed more good times lay ahead based on the rationale that home prices never dropped nationally. (As an aside, Toll Brothers (NYSE:TOL) share price rose similarly, though its P/E multiple only averaged 13 in 2005.) Paulson bet against the conventional wisdom and rolled sevens.
Tepper, in contrast, bet that the banks that supplied many of the subprime mortgages that financed the housing boom were going to survive. If you think back to a year ago, the more dire chatter portended many of the major banks being nationalized. The overarching pessimism presented Tepper with the opportunity to buy Bank of America (NYSE:BAC) shares for less than $3 each and Citigroup (NYSE:C) preferred shares when the stock was less than $1.
Paulson shorted excessive optimism, while Tepper invested long on excessive pessimism. I believe Tepper's strategy is easier to ape for most investors, because the long market is the more efficient market. What's more, despite the S&P 500's ascent from the March 2009 lows, pockets of excessive pessimism still exist, most noticeably in the following six issues.
|
FIRM |
Issue |
|---|---|
|
SuperValue (NYSE:SVU) |
Big-box discounters will continue to erode margins and revenue growth. |
|
Boston Scientific (NYSE:BSX) |
Lack of product development has meant missed market opportunity. |
|
Wendy's/Arby's (NYSE:WEN) |
Fierce pricing competition will make it difficult to rebound from recent losses. |
|
JetBlue |
Any pricing opportunities will fail to offset rising fuel costs. |
|
DryShips |
Slow economic growth will continue to hit high-fixed-cost industries hard. |
|
Pulte Holmes |
Many homebuilders aren't expected to survive the bursting of the housing bubble. |
Reasonable expectations
Don't expect this selection of misfits to provide John Paulson- or David Tepper-like returns. Paulson and Tepper both employed highly concentrated positions (and possibly a lot of leverage). And though, I'm generally for concentrated investing, I think their level of concentration is too much for most investors (including me), because few of us can time the market so accurately. Plenty of investors saw the housing bubble forming and plenty of investors saw pessimism in the financial stocks running high, but they either bought or sold too soon.
And buying and selling too late or too soon has been the bane of my investing career, but not the end of it. Here's a typical example: I bought shares of Ford at an average price of $6.50, in 2006, after years of disappointing news and poor financial performance only to subsequently see even more disappointing news and more poor financial performance that drove Ford's share price down to a buck. But that was yesterday. Today Ford is trading over $10 a share.
It's not the stuff of Paulson or Tepper, to be sure, but it is the stuff of many successful contrarian investors.
