Investment Week columnist David Stevenson gets Mundy’s views on the purity of his portfolio and how a contrarian operates in volatile markets.
David Stevenson (DS): You are a self confessed contrarian. But markets over the past 18 months have lacked direction. Has that made things difficult for this style?
Alastair Mundy (AM): Yes, we have not been doing a lot, but a lot of the time we do not do a lot.
I think if we were absolute pure contrarians, we would be looking for absolute value, but we have more of an institutional mentality, so look at things in relative terms.
We always get opportunities because there is always something rising relative to the market and always something falling relative to market. However, we do find lots more opportunities when markets are falling.
As a result, we have not had a lot of new ideas in the last 12 to 18 months. However, that is not the same as saying our portfolio has not got anything exciting in it. You have got to look at the ‘stock' and the ‘flow' of a portfolio. The stock is all the things that have been added to the portfolio in the last five years and may now be moving up from distressed valuation towards fair value.
The flow is the new stock ideas, which will replace cash or stocks that have now got to fair value. So the stock has been fine but the flow has been lacking. And so at that point you say - as long as the stock is good, then I am prepared to be patient and wait for new ideas.
The problems only really arise when you hold onto that stock, it goes to fair value, you sell it and you still have not got anything new coming in. Then you have got to start being incredibly patient, and asking your investors to be patient.
DS: So to use your distinction, let us look at the stock and flows individually. Looking back at 2007 and 2008 vintage stocks, which stocks have done really well for you?
AM: The vintage that quickly corrected itself was the 2008 vintage. A lot of it was trash and we still believe a lot of it is trash. I am going to mix my metaphors badly, but we thought a certain number of babies had been thrown out with the bath water, so for every hundred trashy stocks, there were ten stocks in there that were really good.
And those are the stocks that have really driven our performance over the last year.
These were stocks such as Signet, the jewelers and Travis Perkins.
DS: What about your old vintage stock of companies?
AM: We are still overweight the 2004/2005 vintage. This is the large stocks such as Glaxo, AstraZeneca and Unilever. I think there has been this institutional move away from very large companies for the last decade.
I am convinced this is because fund managers think it is very hard to say how smart they are if they have to go and tell their clients they have been buying Glaxo. As part of an aversion to indexing, people have overlooked the merits of mega large caps.
DS: So a fear of being accused of being a closet index tracker has produced its own behavioral biases has it?
AM: Yes, it has created this behavioral bias away from sensible stocks because you have got to show you are doing everything you can to add value. This is even if Glaxo is cheap, it is always better to find something that may be less cheap, but sexier!
DS: But have these very large companies become better investments over the last few years? Are the underlying business franchises any stronger?
AM: As things got tough, these large companies have had to face up to the real world. Many have changed their boards. And what we have seen, particularly with the drug companies, is these companies have been dragged kicking and screaming into modernisation, turning from bureaucracies into modern businesses.
DS: Turning away from the existing stock of companies, what about the flow? What has your turnover been like in the last twelve to eighteen months?
AM: Very low. I should think we have probably only turned over about 20% of the portfolio. It has been very opportunistic. Not as in extraordinarily cheap, but just opportunistic. And even then, there has not really been much coming in because over the last three to six months we have never had so many upgrades relative to downgrades in markets. So we have not seen many blowups to buy.
DS: So you have not had many really cheap, blow-up shares where investors have capitulated and run away? What has powered most of the recent shares coming into your portfolio?
AM: It has been disinterest on the part of investors, rather than investors capitulating. For our part, we do not mind. We will happily feed off capitulation or lack of interest.
DS: What have you bought in the last twelve months that demonstrates that lack of interest argument?
AM: Things like British Land and Land Securities, where in relative terms they have not bounced at all.
DS: You are not worried that commercial property might go through another dip?
AM: We go to bed worrying and we worry if we have not got anything to worry about because it is usually those things that cause you most distress. But there is no perfect investment out there, and when you buy something, you look at the positives and you look at the negatives and you ask yourself whether you are being paid enough to take on the negatives.
The nice thing about the property companies is that they do, in general, hold very long, good properties, with pretty long leases and pretty good balance sheets.
DS: Have there been any capitulations?
AM: We've bought things like power generator Drax and SIG.
DS: Why a company like Drax? Is it not a play on the differential cost of producing energy from gas versus, say, coal?
AM: It competes against gas fired and nuclear stations, and we believe the relative advantage held by one type of production at any time may be very important to profitability. As a result, profitability can be very volatile.
The recent rights issue alerted investors to how important it is for the company to maintain a strong balance sheet at all times. With gas prices currently very low (and therefore working against the profitability of coal fired stations) investor sentiment is very poor.
However, the gas price is notoriously volatile, and while there are a number of arguments as to why it should remain low, there are an equal number of reasons for the opposite to occur. With the market strongly betting on a low gas price, we have a reasonably attractive valuation on which to buy the shares.
DS: Have you got much small to mid-cap exposure at the moment?
AM: No, very little exposure. One of the things I have learnt over the years is, for whatever reason, our approach does not work very well in small caps and
one of the most important things is, if you are not good at something, stop doing it! So in general the only small caps in which we invest are those with solid business franchises.
They may have lost their way because they got bored with that franchise and tried to stretch it, or they bought up other things without such a strong franchise and have now gone back to their core business. Companies like Games Workshop, which we have now sold.
DS: Traditionally you have invested a lot in the closed end fund sector. Have you done anything in that area?
AM: Yes, we have looked at it with a great deal of interest. However, there were shocking discounts and a lot of those shocking discounts arose because the trusts were highly geared.
Therefore, when we looked at the discounts to gross value rather to net value, they did not look so appealing. Investors were hoping to buy uncorrelated assets and all they got were correlated assets because they were all in the risk asset pot.
Also, the assets in these funds were not as high quality as they could have been. For that reason, we have looked and looked but we have been constantly disappointed and have avoided many of the trusts.
DS: You have invested in the past in a lot of listed structured products. There was enormous stress in the structured product market when Lehmans went down and prices moved down significantly. Did those prices tempt you back into this particular space?
AM: Yes, we did move into some structured products because imbedded within them were corporate bonds - mainly banks - and even if we did not know whether those banks were going to go bust or not, we could see how those bonds were trading and could compared that to the price of the structured products.
This is a good example of the type of opportunity we like. We are looking for are things where people are capitulating because they do not understand what they have bought.
DS: Looking forward have you noticed a pick up in opportunity, better flow coming into your portfolio?
AM: Things are coming our way. Yes, we still have not done much but if this lasts a little bit longer, we are going to see some very interesting buying opportunities.
DS: Do you think the current upsurge in volatility will last much longer?
AM: There are lots of very good reasons to be fearful out there and it gets harder with each new disaster to brush it off.
DS: Are you taking risk off the table or are you putting it back on?
AM: I think we are doing a bit of both really. We are trying to find things where risk is overdone, to buy, and for protection. We are also trying to find things where we think we can buy risk cheaply. This volatile market throws up all sorts of opportunities.
DS: What kind of themes are you looking at?
AM: The strongest theme is the need to buy insurance policies, against something we are not sure is going to happen and are not sure we need to worry about.
We are looking at the unintended consequences of policy outcomes at the moment and whether we need to guard against inflation or deflation - or devaluation of currencies or social unrest or rioting on the streets. There is no one size fits all insurance policy, so it is all about looking for different opportunities in different markets.
DS: Just to pick two particular themes out there, would you be a buyer of BP and the oil equipment companies at the moment?
AM: Looking at BP it is quite clear no one has got any idea what the truth is and we probably may never know, or will not know for years. And also, we have no idea what fines could be imposed upon them.
Having said that, stock market history tells you that not many companies tend to be destroyed for things that go wrong, whether it is tobacco companies or pharmaceutical companies.
DS: What about gold?
AM: We started buying gold shares around three and a half years ago, and added to them in 2008. No-one knows if it will work as an insurance policy. Because gold shares are a derivative of gold, there is even less guarantee that they are going to work when needed.
It does disturb us a little bit that so many clever people are buying it, because it may become a risk asset and a correlated asset class as well. Gold does seem to have certain characteristics which work at both ends of the unintended consequences curve, so perhaps it will work in a deflationary environment or an inflationary environment, or if currencies get devalued.
We would pick gold shares rather than gold because they have historically been highly geared to the gold price.
DS: Let us look at fund management generally and particular styles of investment. Do you think it's possible to be a real contrarian in equity markets these days?
AM: Not to sell it to the retail investor. And it is also difficult to sell it to institutional investors because ideally what you would like is to have the capacity to be, say, 50% in cash if you can not find enough good ideas.
In the retail market we are restricted by the rules of the governing bodies where we have to be, for example, 80% invested in equities. Most clients will be saying, ‘why are we paying you a management fee if you haven't got any good ideas?' And so for that reason, you do have to perhaps temper the purity of your investment process.
We all have to play by certain rules: If you join a golf club and they tell you not to dance naked on the dinner table at midnight, you stick to that rule. As long as you have come to an agreement with your clients and you are both happy to manage the money in that way, then you have both agreed to forgo the purity of the process.
DS: A contrarian might have lots of cash but a contrarian might also be defined by a very focused portfolio. Many contrarians will only pick five, ten, fifteen, twenty or twenty-five slots and go for it.
AM: Yes, absolutely. And it is funny how conventional wisdom leads people to believe they need seventy to eighty stocks for a diversified portfolio. Pension fund trustees, for example, would never think fifteen or twenty stocks was diversified enough. The academic world, in contrast, suggests the lower number gives you proper diversification.
Buffett always said to put your eggs in one basket and watch that basket carefully. If you know your stocks really well, then we would argue that can reduce the risk. If you have got seventy or hundred stocks in the portfolio you run the risk of not knowing them as well and therefore running a high risk portfolio.
DS: How many have you got in your portfolio?
AM: Well on the UK side we have got thirty stocks that make up about 80% of our portfolio. We are pretty high conviction.
DS: Could there be a space for very a high conviction sub-twenty stock fund?
AM: There is definitely a place for it. I do not believe it will be a big selling fund because of what I just said - because conventional wisdom would tell too many people that that it is wrong, but that is what gives the opportunity.
Contrarianism, in its simplest form, just sounds as though you are buying anything which goes down. But as some deep value investors discovered in 2008 that can really leave you with some shocking performance. You have got to buy stocks which are on very significant discounts to their fair value, but also you have got to have confidence that the fair value is not going to fall very significantly and you are not going to suffer permanent capital loss. T
he greatest chance of suffering permanent capital loss is by the presence of a large amount of debt on the balance sheet. If you look at the biggest hundred bankruptcies ever, most of them were brought on by the debt burden rather problems in the actual business side.
DS: Do you find yourself looking at your list of holdings and worry about index hugging?
AM: Yes!
DS: Do you honestly think you are true enough to your contrarian beliefs at the moment?
AM: That is a great question. I think within the realms of being gainfully employed, yes. Jeremy Grantham calls it career risk. Perhaps everyone would like to do things slightly differently, but you can not run the risk of having to go home and tell the wife you are unemployed.
Now, does that mean you have made worse decisions for investors than you would have done? Well not necessarily because your investors, even though they might claim to want your pure process, might not be able to handle it. They always come back to [the film] A Few Good Men when Jack Nicholson says to Tom Cruise, "you know, you can't handle the truth". T
here are definitely investors out there who think index hugging is a terrible thing. But you give them a pure portfolio with greater volatility and they would complain that you could lose them too much money.
