Sticking with unloved companies can pay off

It's 31 March 2010. It's 84 minutes into the first leg of a Champions League quarter-final and Arsenal fans have witnessed the best football they've ever seen in their new stadium.

Unfortunately, their team hasn't played it. They're 2-1 down to Barcelona and lucky not to be losing 5-1.

But there's nothing lucky about the next goal. Arsenal captain Cesc Fabregas steps up to take a penalty. He smashes the ball down the middle of the goalmouth as the keeper dives. The net billows. Fabregas has won the unlikeliest of draws with the most predictable of goals.

The goalkeeper would have been better off standing still. I learnt this fact from a book about investing.

The Little Book of Behavioral Investing, by James Montier, is a summary of research into behavioural psychology applied to finance.

One study tells us that a third of the time penalty takers strike the ball at the middle of the goal where it's easiest to save, but goalkeepers almost always dive left or right.

Asked why they don't stay in the middle more often, they say they'd look foolish when corner shots go in. This bias towards action is intensified after failure. Make a fool of a keeper once and he's even more likely to dive next time.

What's this got to do with finance?

Like goalkeepers, fund managers are under pressure to perform, and it's safer to do what the crowd thinks is best than to stand out from the crowd. Investors might jeer, and they'll certainly withdraw money from a fund manager who is unconventional and losing money.

Sticking with poorly performing investments is embarrassing at best. At worst, it can lose a fund manager his or her job.

But buying shares in unfashionable companies and sticking with them until they've proved their worth is exactly what contrarian investors such as Anthony Bolton do, and may explain why managers like him are so rare.

Even Bolton endured periods running Fidelity Special Situations when the market outpaced him.

Such periods are inevitable - it was the eerie consistency of fraudster Bernard Madoff's returns that made his rivals suspect they were bogus.

A reputation like Bolton's helps to tough out those periods. However, without that reputation, the safest thing do is to follow the herd by buying the same fashionable companies and selling the same unfashionable ones as most other fund managers.

The pressure to conform when things are going badly, even though it guarantees mediocre returns, is so strong, says Bolton, that he has "always thought the best environment in which a fund manager could perform well was one in which they didn't know how they were doing".

US hedge fund manager Michael Burry thought he'd found a way of ensuring dips in form didn't matter by locking investors in for a year.

Michael Lewis's book The Big Short documents how Burry first worked out how to profit from defaulting mortgages. Between 2005 and 2007 he turned his fund into a giant bet against the housing market, even though house prices were rising inexorably.

His clients complained that he was taking unbearable risks, but many were trapped. Burry won his bet and made investors hundreds of millions of dollars. However, the experience was so painful for many clients that they deserted him as soon as they could.

The pressure to retain the confidence of readers also drives columnists to conform. I expect the contrarian companies in the Thrifty 30 portfolio to beat the FTSE All-Share index handsomely over five years.

Until then, I hope you'll use the Share Sleuth performance chart (see table below) to understand the pressure I'm under rather than judge my success. Otherwise, in publishing it, I might be scoring an own goal.

Richard Beddard is companies and markets editor of Interactive Investor and a keen private investor. He writes about companies on the Interactive Investor blog.

This article was originally published in Money Observer - Moneywise's sister publication - in May 2010

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