Steve Romick’s tips to become a great contrarian value investor

“Stocks go up…Stocks go down…Sectors do well, sectors do poorly. It’s entertainment! Ultimately, I don’t find it very valuable. It’s no more than tabloid reporting,” he said in a speech at a value-investor conference in London.

Romick is the founding partner of First Pacific Advisors, a Los Angeles-based institutional investment firm. He serves as portfolio manager of the FPA Contrarian Value Strategy. Prior to joining FPA, he started his own firm, Crescent Management, in 1990.

Why argument against active investment management is uncalled for

According to Romick, active investment management is often criticised due to high fees and lackluster performance.

Although he doesn’t refute this claim, he underscores the belief that passive investment is always going to look great during a long-lasting bull market.

He says critics of active management focus too heavily on performance each year, ignoring market performance over full-market cycles, which he calls, “short-termism.”

“This is a breeding ground for all sorts of cognitive dissonance to which smart people fall prey when trying to adapt and join the crowd,” he says.

According to Romick, the argument against active investing is fundamentally flawed because it assumes that only the best performing stocks will drive returns.

“The argument doesn’t consider the other side. If you avoid the worst-performing stocks, you can still put up good numbers,” he says.

Contrarian approach

According to Romick, many investors follow a contrarian approach to investing which is to buy stocks and get more than what investors paid for those stocks either because good businesses are facing a cyclical challenge or because investors do not fully recognise the quality of that business

He says, in either case, assets that are mispriced in this way resulting in a rate of return that is better than the market’s.

“The goal is to generate long-term equity-like returns, take less risk than the market and avoid permanent impairment of capital,” he says.

According to him, investors need to focus on finding out-of-favour, low-risk/high-return investments in various parts of the capital market.

“In my early years, I ended up too much in the weeds. I had to know everything about a company and its industry. I’ve since learned that knowing less is okay as long as you have identified the one to three things that will drive the company. We believe exactness offers little so we prefer to establish a potential range of outcomes instead. We’d rather be directionally right rather than precisely wrong.” he says.

Key components of successful investing

Romick says patience and avoiding fads are key components of successful investing.

“Frankly in this age of Instagram and Snapchat when immediate gratification seems to rule our lives, few portfolio managers have the patience to remain disciplined through their inevitable difficult periods, and even fewer clients are willing to stay with their underperforming managers. But winning over time requires enduring short-term ups and downs,” he says.

He looks at the economy, industry and company trends, and meets the top executives of his major holdings to find investments worth owning.

Romick says his priority since starting the fund in 1993 has been to limit losses, rather than maximizing returns.

Goals of a portfolio manager

According to Romick, beating the market shouldn’t be the goal of investors but it should be to provide, over the long term, equity-like returns with less risk than the stock market.

“We have beaten the market, but that‘s incidental. We don‘t have this monkey on our back to outperform every month, quarter, and year. If we think the market is going to return 9% and we can buy a high-yield bond that‘s yielding 11.5% and we’re confident that the principal will be repaid in the next three years, we‘ll take that. If the market rips and goes up 30%, we don‘t worry about it. We don‘t feel the onus to be buying juice all the time, because that can sometimes turn into disaster. We are absolute value investors. If we felt the need to be fully invested at all times, then we would have to accept more risk than I think we need to,” he says.

Romick says it is very important to have a macro backdrop and not be invested in certain areas of the market.

“We don‘t have a crystal ball and don‘t believe that we understand the economic picture better than everyone else. At certain points though, we feel that there is enough uncertainty that could lead to either some pretty ugly out- comes or even wonderful outcomes,” he says.

How contrarian value investing is different from value investing

Romick says investors tend to think of value investing as owning the shares of a proven business in frequently cyclical industries that do not have much growth.

They consider growth stocks to be those shares of businesses that can seemingly grow at a healthy rate for years and have less economic cyclicality.

Romick states that investors should view contrarian value investing as buying growing businesses at a price that can offer a margin of safety that protects capital if all does not go as planned.

Traditionally that protection comes from a company’s balance sheet, that is buying below book value, or maybe by getting some unrecognised real estate value or some other hidden asset, he says.

Focus on evaluating businesses

As per him investors need to understand what changes are likely for a business and whether the business will be a winner or a loser over time.

“It is important to avoid those losers and to avoid overpaying, even for an excellent company. A winning business does not necessarily translate to winning stock,” he says.

Romick says contrarian value strategies are expected to under-perform in markets where price does not matter particularly those characterised by great confidence of what might be but is yet to be proven.

“These are those businesses that are not earning money today, but investors expect them to be earning in 10 years and hence their business models are still untested,” he says.

Romick says contrarian value strategies should outperform in those periods where an industry group or an asset class falls from grace.

“We could do well by avoiding some of the weakness as prices fall and possibly by picking up inexpensive good assets in weaker market conditions,” he says.

Romick says investors need to examine what businesses are more likely to thrive a decade from now and those that could be struggling.

He says thinking with this mindset forces investors to continually adapt to the expected changes that are going to come.

Applying contrarian value

Romick says different businesses have different fundamental economic characteristics and should be traded and valued on different numbers. What is a margin of safety in one is going to look very different in another.

“In digital businesses for example, you may have very low or no marginal cost of revenue or customer acquisition. What that means is that things like scale advantages, or the likelihood of reaching them are a lot more relevant than what is on the balance sheet or maybe the historic income statement. The fact that the business did not make money two years ago becomes irrelevant to their prospects five years out,” he says.

(Disclaimer: This article is based on various interviews and speeches by Steve Romick)