At our 2019 Annual Address, we highlighted seven stocks in the Odlum Brown Model Portfolio* that performed especially poorly last year. Surprisingly, the audience reacted with chuckles. Perhaps that was because of the guilty looking dog we projected on the screen. We suspect some of the quiet laughter reflected relief that we were acknowledging our mistakes.
Investing is a humbling affair and it’s always wise to recognize errors; but, that was not the purpose of the discussion. Rather, it was to suggest that selling the dogs when they are loathed and depressed would likely exacerbate the situation.
It’s natural to have doubts when investments disappoint. However, doubt can damage your portfolio if it promotes selling at an inopportune time. Most investors perceive greater risk when stocks go down, but the opposite is often true. The risk of losing money goes down as prices fall, while prospective returns go up. Think of it like a teeter-totter: price/risk on one end and return on the other.
We have owned frustrating stocks before, and patience has yielded big rewards. Not all dogs recover, but history and our own experience suggest many dogs will have their day. That has certainly been the case this year. The seven stocks highlighted at the Annual Address produced an average return of 31% for the year through to mid-April, led by Coty Inc. – our worst performer in 2018 – with nearly a 70% return. Comparatively, last year’s 10 best-performing stocks yielded an average return of 13%; that’s less than the 16% and 15% returns for the respective S&P/TSX Composite Index and the S&P 500 Index ($CDN).
While this recent experience highlights the potential benefits of a contrarian investment approach, it would be a mistake to get carried away betting on the laggards. We believe our dogs have done particularly well this year because the general disdain for such stocks was extreme late last year.
In fact, it was the first time in many years that we felt investors were irrational and unjustifiably negative toward a group of stocks. In a December 20, 2018 Market Comment titled, “The Storm Will Pass,” we identified leveraged businesses, Canadian energy companies and U.S. housing-related stocks as severely beaten up and discounting an overly pessimistic outlook.
Investor sentiment has improved considerably since then, and the valuation spread between loved and unloved stocks is not as extreme; as such, the odds the dogs will outperform are no longer as good.
Moreover, contrarian investing has generally not worked well in recent years; it has been more profitable to ride the winners. While that might seem intuitive, it is not always the case. In the Model’s first 10 years, we regularly took profits from our winners and reinvested them into the laggards. This strategy worked very well and produced a compound annual return of roughly 20% between 1994 and 2005.
But, times have changed. We live in a more challenging, slower-growth world, in which the competitive advantages of the best businesses are fortified. Technology, increased regulation and globalization are key reasons for this trend and are unlikely to change. Our investment style has evolved to reflect our view that the best businesses are most likely to thrive in this economic environment. It’s not like the good old days, when a rising tide lifted all boats.
Still, we reflect on the strong performance of our dogs this year as a reminder that contrarian investing is not entirely dead. It’s a strategy that works when investor sentiment is excessively negative. It’s worth remembering the expression “every dog has its day” the next time you feel anxious about a bad market and the dogs in your portfolio.
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* The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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