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A contrarian view of the stock market in troubled times

After a year of living dangerously, these Canadian contrarians take a hard look at choices in the market and several stocks that are down.

We’re well into the first month of 2008, so it may seem a little late for yet another look back at 2007 and glance ahead at the year to come. But we’ll make an exception in order to accommodate some rather stimulating contrarian views.

They come from Contra the Heard, a Canadian market letter that appears four times a year. It is pointedly not an advisory, since it offers no buy, sell or hold advice to its subscribers. Putting their contrarian views to work, the “Contra Guys” invest in certain stocks and comment on the progress of those stocks.

These hardy investors have some blunt comments on their own portfolio — it lost 15.5 per cent last year, although the newsletter’s five-, 10- and 15-year returns are in double digits the other way, with gains of 15.4 per cent, 16.2 per cent and 21.8 per cent, respectively. As for the overall picture in the markets, they have some observations that do not stick to the beaten path.

We begin with the big picture.

A very average year

The year 2007 may have ended badly on the markets, but it wasn’t the end of the world. “After all the whining and whimpering that made 2007 sound like we were going to hell in a handbasket,” say the Contra Guys, “when the numbers for the main North American indexes were tallied, it actually turned out to be a very average 12 months.”

The numbers ranged from a high of 9.8 per cent for the Nasdaq exchange to the S&P 500’s 3.5 per cent. Both S&Ps (the 500 and the TSX) were on the plus side for the fifth straight year. “While none of these numbers are anything to crow about, they’re all in positive territory and close to historical norms — that’s nothing to sneeze at.”

Big bucks were being made at other stops around the globe. China’s CSI 300 benchmark exchange soared by 161 per cent. The Bombay Stock Exchange’s Sensitive Index jumped 47 per cent. Brazils’ Bovespa index was up 44 per cent, the KOSPI index in Korea was up 32 per cent — its fourth double-digit gain in five years — and Malaysia’s KL Composite Index rose 31 per cent.

Singapore’s Straits Times index was only up a “dowdy” 16.6 per cent. And then there was the incredible figure from Zimbabwe, where the market rose 322,111 per cent. In fact, that number is not at all credible, due to “that hyperinflation thing.”

There were overseas markets that sagged — in Japan, Ireland and Venezuela, notably — but “2007 was definitely a time to be chasing returns in emerging countries.”

A roadblock on the road of progress

For all the hand-wringing that’s going on in the markets now, a change for the worse was probably due, say the Contra Guys, and not just for the obvious reasons.

“Given the overall performance of markets since the tech bubble deflated,” they observe, “might it be time for a regression to the mean? The air, of course, is thick with worry. Subprime mortgages, a credit crunch, big debtloads, recession, high oil prices, wars, global warming — all are reasons to question whether the end is nigh for this boom.”

But the primary reason for regression may be even simpler. Economies that are chugging along simply have to gear down from time to time.

“Chief amongst the concerns is the fact that, after a number of years of positive returns, even the best economies tend to have problems, setting up a roadblock or two on the road of progress.”

Yet even if that scenario plays out, there is one reason for at least a modicum of optimism. It’s a presidential election year.

In these circumstances, because “governments and bankers will likely pull the levers of stimulus to avoid an economic debacle, perhaps the day of reckoning will be postponed.”

Both sides of the fence

How do contrarians play a tricky situation like this? “We’ll bet both sides of the fence, content with our 21 stocks, while, as usual, having lots of money on the sidelines with which to jump in should the spanking of the markets intensify or in the event that the odd exciting cherry is ripe to be picked.”

In the meantime, the Contra Guys take a hard look at their own less than scintillating year on the market. You don’t have to be a contrarian to draw some enlightenment from this.

For one thing, they were invested in just 15 stocks for most of the year. “Our crappiest returns have coincided with periods when we’ve had less capital invested.” In other words, the damage could have been even worse.

“Conversely, when we have been more confident that the market is contrarian-friendly, we have invested at close to full throttle and been rewarded with much better numbers. What’s that about diligence being the mother of good fortune?”

These investors can’t remember a time when so many of their positions fell by more than 50 per cent. It is a rule of thumb that when investors put together a basket of higher-risk stocks, just one winner can compensate for the losers. But for the Contra Guys, “there were no huge wins,” with only Viterra (TSX-VT), the former Saskatchewan Wheat Pool, chugging ahead by more than 50 per cent (from the time it was purchased in 2005, it went from $5.67 to $12.12). “So, overall, we were ugly on the upside and the downside.”

A successful takeover play

Despite last year’s results, these contrarians see their portfolio as more attractive than the one they held at the beginning of 2004, when they had three huge wins. The reasons for this are worth considering, and not just for contrarian portfolios.

“First of all, our holdings are not heavily weighted in any direction. There is a congregation among tech stocks, but gold and other commodities are conspicuous by their absence.” Oil and gas is also missing, except for a small piece of a “little doggie,” Kelman (TSX-KTI), an energy service company specializing in geophysics and data management.

Real estate is also out of the picture. In the past it was generally a portfolio staple, but even in Canada, which is not plagued by subprime slime, “the demand side of the equation is not what it used to be.”

One thing to be proud of is a successful takeover play. This year, Selectron was the stock in their portfolio that was bought up. That makes 15 years in a row that the Contra Guys have had at least one stock that has been pursued, a signal accomplishment, they point out, among a fairly limited number of holdings.

And how does one treat the Canadian dollar these days?

Cross-border shopping

The relative value of the Canadian dollar is of less concern now, say these contrarians. Over a number of years, they have pared back their exposure to the U.S. greenback, cutting it from about 70 to 50 per cent of the portfolio.

But they’re not counting on Canada’s immunity from any U.S. setbacks. What’s more, the U.S. dollar will not necessarily continue to get pummelled.

Even if the U.S. dollar continues to take a thrashing against other currencies, they say, “the Canadian economy is still so closely intertwined with that of our neighbours that it is hard to see Canada prospering while the U.S. fumbles. And, bearing in mind that this is an election year in the States, it is difficult to imagine a president who might inflict more damage on the national balance sheet than George W. Bush. So, whereas the exchange rate prompted us to curtail our cross-border shopping in recent years, this is no longer the strategy.”

While the approach these investors take to their portfolio is instructive, the contrarian style practiced in Contra the Heard is not for everyone, as they freely admit. This is amply illustrated in two stocks.

Head on a platter

Liquidation World (TSX-LQW) is not only in a contrarian sort of business, cleaning up other people’s messes, it’s in a contraritan sort of position as a stock at the moment. It’s almost catastrophic.

After Hurricane Katrina, it opened up a distribution centre to pick up merchandise it was snapping up at cents on the dollar. That’s the kind of rock-bottom acquisition the company thrives on.

Since then, however, the company has faced “a calamity of its own making,” say the Contra Guys. “Like many Canadian companies that venture into the United States, it had its head handed back on a platter.” It is closing 15 of its 18 American stores. The loss for the past year was $11.7 million dollars.

Short-term debt has swollen, same-store sales are slumping, and the company’s special “events” — the acquisition of products from distressed vendors — are infrequent. Management is taking steps to remedy the situation, moving its headquarters from expensive Calgary to much cheaper Brantford, Ontario, cutting back new store openings, changing its merchandising strategy and hiring a new CFO.

So what’s to like? “If a recession arrives, retail bankruptcies should increase, offering LQW ample opportunities to stock its stores.” Of course, if the politicians manage to stave off a downturn, things will not be so bright for this company. Liquidation World’s shares traded as high as $7.80 in 2004. They opened today at $2.50.

Tantalizing new gizmos

The outlook is somewhat brighter for another Contra the Heard choice, Norsat International (TSX-NII). Say the investors: “The maker of satellite communications equipment has been the perpetual tease, showing signs of progress with a significant contract here, an occasional good quarter there, and tantalizing reports of new gizmos to excite the imagination.”

Still, the overall pattern has been one of disappointment. This is one satellite that just can’t quite get launched. Maybe the time is now.

“Dare we say it, these folks really do seem to have turned over a new leaf in the past year,” say the Contra Guys. Expenses are more tightly controlled, debt paid off and new contracts signed with the U.S. military. Revenues are in double digits and four profitable quarters have been put together. They hope that a promising CEO, Ms. Aimee Chan, will be given time, “because this organization has a tendency to change CEOs more often than Moore’s announces a seasonal suit sale.” The stock, which they bought at $0.65 last year, opened today at $0.72.

Thus they find themselves in the burgeoning industry of mobile satellite communications. “Does this turn us from contrarians into growth players?”

Probably not. And there are undoubtedly many investors friendly to growth stocks that wouldn’t touch this one with a ten-foot pole. But then it wouldn’t be a contrarian investment if everybody liked it. Some might even make the case that contrarians must have a deeper understanding of the market than those who go with the flow. But that’s a debate for another day.

In the meantime, we’ll let the Contra Guys have the last word, because it puts all the agony and the ecstasy of investing in perspective.

They admit that this year figures “took a toll on our egos and our wallets.” But they do not put all of their eggs in the Contra basket.

“Our lifestyles remained balanced with other pursuits, and we enjoy the quality of life this tremendously free and peaceful country offers. Irrespective of how many reincarnations we may or may not have, this is the life we know, and what a waste it would be not to enjoy it.”