Great contrarian investors have a knack of wading into the deep when everybody is running for the shore. They spot value in wounded stocks, stand by their conviction and profit from a fearful market that can only see blood in the water.
This investment style takes great skill. Finding genuine corporate turnarounds is hard enough. Knowing when to buy them and what will re-rate the stock, is the real challenge. Too many contrarians buy fallen stocks too early and destroy capital.
Another form of contrarian investing gets less attention: buying stocks that have rallied hard and are in strong price uptrends. Such investing hardly seems ‘contrarian’; the investor is, after all, going with the market and buying a favoured stock.
But buying high-valued stocks, long after their price rally, can be more contrarian than it looks. As a chorus of commentators argues the stock is overvalued, the smart money keeps buying, knowing that faster earnings growth will justify a higher valuation. They go against the market’s increasingly bearish view on the stock’s valuation.
Consider Domino’s Pizza Enterprises. Many fund managers and stockbroking analysts long argued the stock was overvalued. It took courage to buy Domino’s after its price more than tripled over 2011-14. From $20 in early 2014, Domino’s peaked at $80.69.
The same is true of the internet advertising stocks, Seek, REA Group and Carsales.com. I recall fund managers who argued these stocks were on nose bleeding valuations, only to watch them deliver huge gains. In some way, it took a contrarian mindset to keep buying these stocks when many recommended taking profits.
Contrarian investing is rife with traps. The biggest is “anchoring” expectations against past prices. For example, an investor believes a stock that has fallen from $5 to $1 must be cheap and that it will inevitably return to $5, even though it is now a different company.
Similarly, a stock that rallies from $1 to $5 must be expensive. Novice investors judge the stock on where it has come from, not where it’s going. The best fund managers I know let their profits run in these stocks, confident that faster earnings growth will justify the rising valuation.
Another contrarian trap is basing investment decisions on simplistic metrics, such as Price Earnings (PE) multiples. The fallen stock on a PE of, say, seven looks super cheap, even though the PE is inflated because another earnings downgrade is coming. Conversely, the rising stock on a PE of 30 looks expensive, but the PE will fall as its earnings rise.
Investor psychology and contrarian investing are inseparable. I find it easier to write favourably about stocks that are well off their high, compared to those near their peak. But fallen stocks, seemingly offering better value and fewer risks, are dangerous value traps.
Technical analysts will see nothing special in buying stocks that are rallying. Momentum traders buy stocks in strong uptrends and sell those in downtrends. Their gift is knowing when to get on and off, as signalled by patterns in share-price charts.
I favour fundamental over technical analysis, but often combine both techniques in contrarian investing. Technical analysis can identify when a fallen stock has formed a base and is trending higher; and when the rally in an uptrending stock looks exhausted.
Whether one believes in technical analysis or not, it is a gauge of investor psychology, which is so important in contrarian investing.
Here are three stocks in strong uptrends that can rally further:
1. BWX (BWX)
Shares in the cosmetic group have soared from a $1.50 issue price in its 2015 Initial Public Offering to $4.87, making it one the best floats in years. BWX raised $39 million to develop skin and haircare brands that include Sukin, DermaSukin, USpa and Edward Beale.
BWX looks expensive, on a trailing PE of 34 times at the current price. But expected annual sales growth of more than 30 per cent, in a high-margin segment, will boost earnings and lower the PE. Some brokers have BWX trading on a forecast FY18 PE of about 20 times.
BWX needs rapid earnings to justify the valuation and re-rate its stock further. A distribution deal in the United Kingdom, through leading pharmacy retailer, Boots, expands BWX’s international footprint and adds a new engine to its earnings growth.
Longer term, I like the outlook for ‘affordable cosmetics’ and natural skincare products, a market that BWX leads in Australia. The boom in middle-class consumption in Asia will drive higher sales of mid-price cosmetics and haircare products.
A pullback in BWX shares would not surprise given the extent of its rally (the stock peaked at $5.70), and the challenges on managing a fast-growth company. I’d view any correction as a breather in BWX’s journey and a chance to buy at lower prices rather than the start of a prolonged downturn.
[1]Source: ASX
2. Webjet (WEB)
I went cold on the online travel retailer in December 2016, nominating it as one of four small-cap stocks to sell, for the Switzer Super Report. Webjet has rallied from $9.80 to $11.32 since that column, making a mockery of my negativity on the stock!
I fell for the classic contrarian trap. Having written favourably about Webjet’s market position, strategy and execution, I nominated it as a selling candidate based on the extent of its rally. That is, where the stock came from, not where it was going.
Thankfully not too much damage was done and this column is a chance to rectify that mistake. As I wrote in December, Webjet deserved its share-price re-rating.
The company’s business-to-business division is key to its growth prospects. It could be a bigger earning division than the consumer travel business; Webjet expects more than 30% compound annual growth in the business-to-business division over five years.
One can envisage more travel bookings moving from bricks-and-mortar agents, such as Flight Centre, to nimbler online operators, such as Webjet. The disruption story in travel bookings still has a low way to run, and Webjet’s local advantage in this market will help it fight off growing international competition.
[2]Source: ASX
3. Costa Group Holdings (CGC)
The agribusiness group has soared from a 2.25 issue price in its 2015 IPO to $4.34, just below its 52-week high. Costa dominates the berries, mushroom, glasshouse-grown tomatoes and citrus segments, and has an expanding avocado operation.
The business has terrific long-term prospects as local and Asian demand for its commodities grows, and latent value in its technology on different fruit varieties.
Costa reported 9% revenue growth for the first half of FY17. An exceptional performance in blueberry production, up 75 per cent on the prior corresponding period, stood out. Strong export demand for citrus, improving conditions for tomato production and solid gains in the mushrooms business featured.
I rate Costa’s strategy to expand berry production and turn avocados into the company’s fifth produce pillar, thus enhancing its diversification in the cyclical agriculture sector.
Costa upgraded its guidance for growth in after-tax net profit to 25% for FY17, from 15% earlier. It’s a good example of a company that has several growth drivers that are boosting earnings and justifying a higher company valuation and rising share price.
Costa looks the pick of Australia’s agribusiness stocks as it has expanded in China and Africa, and as global demand for fresh produce rises.
[3]Source: ASX
Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at April 4, 2017.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.