How market contrarians win their bets
By Whitney Tilson and John Heins
Kiplinger's Personal Finance
Sunday, November 15, 2009
In his classic book "The Money Masters," John Train recounts how just after the start of World War II, a young John Templeton placed an order to buy $100 worth of every stock that traded on a
Once all the orders were executed, Templeton owned shares in what Train calls a junk pile of 104 companies (34 of them in bankruptcy) for a total of about $10,000. Convinced that war would pull the
Key to success. Value investors are contrarians at heart, buying what's out of favor and selling that which the market loves. But taking a contrarian's view doesn't by itself guarantee profits. After all, the market is usually right. To succeed as a contrarian, you must recognize what the crowd believes, have concrete justification for why the majority is wrong, and have the patience and conviction to stick with what is, by definition, an unpopular bet.
Because of the market's spectacular rally since March, it has become much harder to find bargain-priced stocks. Based on average inflation-adjusted profit over the past 10 years, Standard & Poor's 500-stock index traded in September at about 19 times earnings. The market's average price-earnings ratio over the past 130 years is 16.3. So although stocks are not in bubble territory, they're not cheap, either.
In general, the stocks of the most speculative companies have climbed the most, on the belief that the economy is poised to recover sharply. We're skeptical, so we have been positioning our portfolios more conservatively by adding to our short positions, lightening up on stocks that have run up strongly and moving more money into brand-name companies, which have lagged during the rally.
Investors fear that health-care reform will hurt the entire industry, a key reason that the sector trades at just 12 times earnings, or 36 percent below the P/E of the S&P 500 (historically, such high-quality businesses have commanded higher P/Es than the index). We think that the pessimism is overdone.
One way to play the sector is through Pfizer, the world's largest drug company. It holds $10 billion in cash, and at an early-October price of $17, it trades at 8.5 times expected 2009 earnings of $1.97 per share. That's far too low for a company of its caliber.
Facing strong competition from Google and having botched its proposed acquisition by Microsoft, Yahoo is also out of favor. By 2011, we expect Yahoo to generate annual earnings before interest, taxes, depreciation and amortization of $2 billion. To that figure, we apply a multiple of 10 because Yahoo has a business model that requires relatively little capital. Add another $16 billion for the value of Yahoo's cash and its stakes in Yahoo
Going against conventional wisdom isn't easy. Leave it to Berkshire Hathaway's vice chairman, Charlie Munger, to offer a simple and powerful rule of thumb for doing so: "Learn how to ignore the examples from others when they are wrong, because few skills are more worth having."
Columnists Whitney Tilson and John Heins co-edit Value Investor Insight and SuperInvestor Insight. Funds co-managed by Tilson own shares in Pfizer and Yahoo.
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