Contrarian Beliefs Lead to Outsized Returns
It’s easy to follow trends and chase the latest shiny object. In tech over the last few years, industry hype has followed anonymous messaging apps to blockchains to chatbots, with many others in the way. While these fields could have real merits, the truth is that it’s too late to enter the space when it is ‘hot’ and reported on daily by TechCrunch. Successful teams have usually been working on the problem for some time, deepening their domain expertise and building an early defensive moat.
Success comes from seeing opportunities before the broader market does, and having the conviction to act.
This has a direct parallel in the world of equity investing. Stocks begin the cycle by being generally invisible to the market, ignored by analysts, and undervalued. At some point, early contrarians notice that underlying fundamentals are sound, and invest. Over time, stock-picking models notice the divergence between analyst estimates and actual earnings, and begin to make allocations. The tide begins to turn and the broader market starts to notice. Expectations and consensus estimates rise, leading momentum-driven investors to get involved. And all the while, prices rise in accordance with growing demand, until the security is perhaps overvalued.
Interestingly enough, Merrill Lynch has a sell-side indicator which uses this logic as a quantitative signal. In a report, they declare: “We have found that Wall Street’s consensus equity allocation has been a reliable contrary indicator. In other words, it has historically been a bullish signal when Wall Street was extremely bearish, and vice versa.”
That’s a bold statement. Consensus allocations are inversely correlated with future returns. Securities that are ‘hot’ underperform, and those that are ignored outperform.
This makes me think of the famous question posed by Peter Thiel to entrepreneurs: “What is something you believe that nearly no one else does?” This probes for original thinking and acknowledges an underlying truth: contrarian beliefs lead to outsized returns.