Weekly outlook

Why it pays to invest against the tide

By Tom Stevenson, 13 May 2009

As the market makes a fool of the conventional wisdom once again, investors can see the benefit of a contrarian approach.

Six months ago, I wrote a column here marvelling at the speed with which the investment world had turned its back on the emerging markets "decoupling" story. The backdrop to that piece was an implosion of the previously high-flying stock markets in the developing world. The day before I wrote, the MSCI Emerging Markets index had fallen 11%, its biggest one-day reversal since the 1987 crash. On that day, trading in Brazil was suspended as "circuit breakers" were triggered by a 15% fall in that country’s main Bovespa index. Since the beginning of the year, emerging market shares had halved in value as commodity prices tumbled and exports to the developed world dried up.

"What was amazing about the fall from grace of emerging markets was how quickly investors had ditched their previous view of the emerging markets story." Tom Stevenson

What was amazing about the fall from grace of emerging markets was how quickly investors had ditched their previous view of the emerging markets story. Only a few months earlier, the consensus had been that emerging markets had got their act together since the crises of the late 1990s.

With now rock solid balance sheets, the likes of Brazil, China, India and Russia were also able to boast impressive domestic demand stories which would make them immune to the downturn in the West to which they sent their exports. As recently as May last year, emerging market stocks were close to their all-time high.

But by October, that belief had been abandoned. Emerging market stocks were cheaper than they had been since 1998. The gap between the yields on emerging market sovereign debt and those on US Treasury bonds had widened to a four year record.

The outlook for emerging market stocks in October was awful. And yet, six months on, as the chart below shows, it is clear that recovery was only days away. Emerging market stocks hit bottom on 23 October 2008, just two weeks after I reported the abandonment of all hope. Once again, investor capitulation had marked the bottom of the cycle and the beginning of recovery.



Since emerging market stocks hit their low, they have risen by more than 30%.

Every time this happens it takes investors by surprise. The recent upturn in the market provides another compelling example of how the market can confound expectations. The rebound from the March lows has been pretty widespread but one aspect that has not been widely reported has been the out-performance of small cap stocks. Again, this has defied the conventional wisdom.

Smaller companies are more economically sensitive than larger businesses. The most defensive areas of the market like utilities and pharmaceuticals have hardly any small companies. Small businesses have less diversified product ranges. They also struggle to access debt markets and find it harder to obtain bank borrowings.

In March, with the market pricing in a re-run of the Great Depression, you might logically have expected the going to be toughest for smaller companies. Indeed as the credit markets seized up and the financial crisis became a deep economic slump smaller stocks underperformed bigger companies. European smaller companies lost 51% of their value during 2008.

As with emerging market stocks, however, the consensus view was wrong. As investors turned their attention to recovery, small cap stocks started to out-perform. Since the March low, as the chart shows, small caps have added more than 6 percentage points more than large caps.



There is a clear lesson to be drawn from the performance of both emerging market and small cap stocks in recent months. It is that by the time a view has become widely accepted by the investment community, it is usually time to bet against it. The time when emerging market and small cap stocks seemed most unattractive was in fact the time to buy them.

Some of the most successful investors have been contrarians, people like Warren Buffett, Sir John Templeton and our own Anthony Bolton. We should not underestimate their investment skill. While it is easy to rationalise what has happened to emerging market and small cap stocks after the event, going against the crowd when the outlook seems most gloomy is a rare talent.