CONTRARIAN INVESTING AND ENTREPRENEURSHIP
Contrarian investing is an approach that might naturally appeal to entrepreneurs. After all, there are some common traits between contrarian investing and the qualities of successful entrepreneurs. However, there are also important differences that entrepreneurs must recognize as they transition from being owners and operators of their own ventures to outside investors in other people’s companies and projects.
From Venture Owner to Outside Investor
Entrepreneurs succeed because of their ability to find a competitive edge. Often there is a contrarian element to this – you don’t find an edge by doing things exactly the same as an established competitor, you find it by looking for ways to do things differently and better.
The nice thing is, when you set your own course with a new venture, it doesn’t matter much whether or not the average person agrees with your business plan. You have a direct relationship with business reality. In time, sales figures, cost savings, earnings growth, etc. will tell you whether or not you’ve hit upon the right approach.
As you transition to being an outside investor though, you will find your relationship once removed from business reality. That degree of separation is the opinion of other investors, which drives pricing. This is abundantly clear in publicly-traded markets, but is also true to a large extent of private equity and real estate. Waves of popularity or unpopularity can drive the valuation of asset classes or particular investments, often in little relation to changes in the underlying business reality.
Seeing how often popular opinion departs from that reality, it can be tempting to pursue a purely contrarian approach to investing ‚Äì if the crowd zigs, you zag. The problem is, this is still letting the opinion of others drive your investment choices, albeit in a contrary direction. That may not always result in choices that best reflect financial reality.
Cycles of Opinion and Reality
We are used to thinking of market cycles in terms of rising and falling prices, but from an investor psychology standpoint we can also think of markets as going through phases where popular sentiment departs from financial reality, and phases where it returns to acknowledge that reality.
Since this wavering sentiment might either over-rate or under-rate the value of investments, this tends to amplify the natural cycle of corporate earnings, as it pushes prices either to unnatural heights during optimistic phases or unnatural depths during pessimistic ones. This leads to situations such as the burst of the dot-com bubble, which saw the price of the S&P 500 decline by 45.6 percent from the end of 1999 through the third quarter of 2002, even though operating earnings of the index declined by less than half that over the same period.
Seeing the market driven to such exaggerated extremes can make a contrarian approach seem not only appealing, but a rational approach to the madness of markets. However, being rational at extremes of market sentiment isn’t always easy. Markets can continue on a delusional course for a long period of time before acknowledging reality ‚Äì certainly for months, and sometimes for years. It is the rare investor who has the fortitude to remain out of step for that long.
Note that the courage to be out of step doesn’t just apply to steering clear of popular market bubbles. It also applies to the negative sentiment phase of the cycle, and having the resolve to buy out-of-favor investments. These are unlikely to snap back into favor right away, and may well get even more unpopular first. The challenge, as long as nothing about your investment thesis has changed, is to react to falling prices by increasing investment rather than by giving into the pressure to bail out.
The Crowd Isn’t Always Crazy
The Scottish writer, Charles Mackay, put his finger on the irrational tendencies of investment markets when he published Extraordinary Popular Delusions and the Madness of Crowds in the mid-19th century. However, as entertaining as it is to read about doomed investment crazes like the tulip bulb bubble, it is important to remember that such tales stand out because they are the exception rather than the rule. In other words, the crowd isn’t always crazy.
Between the highs and lows of popular sentiment, it is important to note that there may also be stretches where market psychology and financial reality are in sync ‚Äì when prices fairly reflect the value of the underlying investments. Thus, while contrarian investing represents opportunity while a market is cycling through one of its overblown optimistic or pessimistic phases, it might lead to wrong decisions at times when investments are fairly valued.
A purely contrarian approach can be especially risky when it comes to troubled investments that people are fleeing. The fire sale that such investments go through on their way to bankruptcy may seem like panic, but often it is the only rational response for an investor in a dying company. Think of it as adjusting to a grim reality once investors realize a company isn’t going to survive. Reflexively buying such a company during this panic selling phase just to be contrarian could mean piling money into a sinking ship.
Two Key Tools: Time and Flexibility
Thus, contrarian investing creates two dilemmas ‚Äì it requires the patience to wait out sustained periods of market irrationality, and forces investors to find alternatives when a fairly-valued market or security makes a contrarian approach the wrong choice. As a rule, it seems TIGER 21 Members should be well-equipped to meet these challenges.
After all, regarding the patience to be out of step with market for a couple of years, entrepreneurs who have nurtured companies from start-up to success understand the commitment of taking the long view. They may even have had to shrug off the criticism of doubters as their companies went through the false starts and setbacks that are often the necessary growing pains that precede success. Anyone with the fortitude to go through this as head of a venture should be able to withstand periods of being out of step as an investor.
As for the reality that popular opinion is not always wrong in valuing markets, TIGER 21 Members have shown themselves to be flexible investors, not just in the breadth of asset classes they hold, but in their willingness to shift allocations among those asset classes as conditions dictate.
What all this comes down to is that a successful investor must be willing to go against the crowd, but simply being contrary for the sake of it isn’t good enough. It is better to think of successful investment approaches as being truly independent of popular opinion rather than reflexively contrary to it. Having the time to wait out popular opinion and the flexibility to cast a wide net in seeking the best opportunities created by misguided opinion are essential tools in exercising such independence.
Thus, as they transition from business owners to outside investors, entrepreneurs should not lose touch with two traits that can lead to success in both pursuits. One is the long-term perspective to wait for popular opinion and financial reality to come back in sync, and the other is the flexibility to exploit a variety of opportunities where the two might be far enough out of sync to create opportunity.
Barbara GoodsteinPresident & CEO of TIGER 21