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When Being Contrarian Isn't Smart

Apr 4, 2017

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Few people - especially those who read investment newsletters - like being part of the "crowd". But, difficult as it is to stomach, "they" are often... right.

What "they" think - whether it's the financial media, or talking heads on TV, or the "conventional wisdom" - is mainstream. It's boring and vanilla. And from an investment perspective, it's like soggy breakfast cereal.

After all, we're told, great fortunes are made by people who go against the grain. Warren Buffett has enough folksy quotations about this - like, "Be fearful when others are greedy, and greedy when others are fearful." - to fill a graveyard full of tombstones.

Then there's the 18th-century British nobleman Baron Rothschild, who is believed to have said something like, "The time to buy is when there's blood in the streets," which is what contrarians tattoo on their foreheads.

Buy when things are bad, bad, bad - right?

At its core, defying the conventional wisdom - the know-it-all on CNBC, the taxi driver who passes on his hot stock tip - is what contrarian investing is all about. It's defying everyone else and conquering your gut instinct, which is telling you to run in the opposite direction.

And in particular, it's the belief that when everything seems pitch-black, blood-red bad, when everyone else is selling... that's the time to buy, because things can't get any worse. And then they get just a bit better, and the brave investor makes a killing.

But some investors take contrarian investing to an extreme. They interpret any bad news, or market correction, or stock decline, or literal blood on the streets, as good news in disguise.

That kind of attitude - knee-jerk contrarianism - is a great way to lose a lot of money, because sometimes - and maybe even most of the time - the boring, plain, they're-all-saying-it conventional wisdom is, in fact, correct.

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Take Ukraine (please)

In April 2014, I visited Ukraine to look at potential investment opportunities. Just weeks before, Russia had invaded and annexed Crimea, a Ukrainian territory. Fear of what might come next was almost palpable. Would the Ukrainian capital, Kiev, be next on the Russian agenda?

"When I'm traveling out of the country, I tell my wife to keep a bag packed," one senior business executive I met with in Kiev told me. "And if there's any sign of trouble, I told her, she needs to get in the car and just drive west."

What's more, Ukraine was a corrupt mess and its greedy politicians had squandered two decades of post-Soviet freedom. At that time, in the years after the 1991 collapse of the Soviet Union - Ukraine had been one of the Soviet states - Poland's GDP had grown six times bigger, Russia's had grown nearly four-fold... and Ukraine's economic output had just doubled.

This was all the stuff that contrarian dreams are made of. And I met plenty of dreamers at an investment conference in Kiev while I was in town - packed even though it was just weeks after Russia kicked in Ukraine's door.

At the time, I believed that it was too early to buy anything in Ukraine. At the time I wrote "... sentiment and valuations are only going to get worse in the near term. So we'll stay on the sidelines for now".

Two of the three stocks that I flagged as potentially interesting (but not then) subsequently fell 27 and 39 percent over the next six months... and were down 69 and 49 percent over the next year. (The other stock I mentioned fell only 7 percent over the next year and was flat over the following six months.) Ukraine was a terrible contrarian bet then.

Today's contrarian trap

Today, it's happening again, this time in Venezuela.

The South American country has the world's largest oil reserves (though it's inaccessible, low-grade oil) - twice as much as Iraq and almost seven times as much as the U.S. And in gross domestic product (GDP) per capita terms, it's about as rich as Poland... and nearly 50 percent richer than people in China.

But Venezuela is a catastrophic mess. "Crisis upon crisis in Venezuela," headlined an editorial in the New York Times yesterday, citing how "precipitously" the country's standing has fallen. Riots, hyperinflation, and rampant chaos are the order of the day. News reports say that the country's hospitals have less than 5 percent of the medicines they need. The only thing where Venezuela leads is in its murder rate.

Could things get any worse? Of course... because they have been getting worse. I visited Venezuela a bit more than two years ago, and it was a mess then. The official exchange rate was 6.3 bolivars to the dollar - but the black-market exchange rate was around 125 bolivars (and now it's about 3,000). Drugstore shelves were full - but of only the handful of products that were allowed into the country (so if you wanted Colgate toothpaste, you were in luck; if you wanted shampoo, tough luck - there was none). And if you were stuck in dusk rush-hour traffic, it was a very good idea to turn off your phone (or any other electronics) because the glimmer could catch the eye of one of the motorcycle-riding thieves who paused at cars paralyzed in traffic - and rapped on the window with a gun, demanding whatever they wanted.

I wrote at the time, "When I look at a country or a market that's in trouble, I always look for a catalyst for change... But in Venezuela's case, I don't see a catalyst. If anything, things are going to get worse... Even if Venezuela's pressing political and macroeconomic problems were somehow solved tomorrow, the country still faces more structural challenges than most countries will experience over the course of a few generations."

The only real way to invest in a traded Venezuelan asset is to buy the country's sovereign bonds (which is difficult and expensive to do if you're not an institutional investor).

After I was in Venezuela an index of the country's sovereign bonds fell about 30 percent. But since reaching a low in early 2015, they've more than doubled, as shown below.

Bloomberg USD Emerging Market Venezuela Sovereign Bond Index

What happened? Nothing improved in Venezuela. In fact, as I said, things have only gotten worse. The country is the definition of a failed state.

This is what happened: Contrarian investors. How much worse could things get? they say to each other. So they buy. And then others follow them, ignoring the real chance that the government may default, or that the country may fall even deeper into chaos.

So far, they've been right. But the real problem is this: What if all the contrarians are lining up together? Then there's no one else to sell to. And eventually, reality takes over.

I don't know if this will happen in Venezuela tomorrow, or next month, or next year. Or perhaps the situation will actually improve, and these investors will be vindicated.

But there are contrarian traps everywhere. Be sure you don't fall into one, by assuming that what "they" say - the conventional wisdom - is automatically wrong.

Please note: This article was first published in Stansberry Churchouse Research on 31 March, 2017.

Kim Iskyan is the founder of Singapore-based Truewealth Publishing. He has spent most of the past 25 years exploring and analyzing global markets. He has been a stock analyst and research director for a big emerging market investment bank, managed a hedge fund, and sold mutual funds to private bankers. He has advised Fortune 50 companies on political risk and helped build stock exchanges from scratch in countries that few people could find on a map. He has lived and worked in ten countries, from Spain to Russia to Sri Lanka to the United States.

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