This article was written by Invesco PowerShares Vice President, ETF Product Management, John Feyerer.
An approach that is zealously employed by some of the world’s most legendary investors, contrarian investing is a disciplined investment approach that systematically acquires assets that are performing poorly and sells assets when they perform well. A contrarian believes that the stock market consistently overvalues the prospects of highly regarded companies, and undervalues those with outlooks perceived to be less attractive. Simply put, a contrarian investor believes that the crowd gets it wrong most of the time, and that a herd mentality can lead to mispricing that can be exploited in the securities markets.
A long-running bull market has stretched equity valuations
Barring a major drawdown, the current bull market will soon become the third-longest since the Great Depression. This remarkable run has generated average annual equity returns of nearly 20% since 2011, and double-digit equity returns in five of the past six years.1 As we approach the second half of 2015, investors may wish to step back, take stock of the markets and identify adjustments they need to make to their portfolios. Of course, you should always talk with your financial advisor before making any investment decisions.
Themes that may be top-of-mind include the increased likelihood of rising interest rates, the impact of a stronger US dollar, the effects of lower oil prices on economic growth, and the persistence of geopolitical risk. We see few signs of improvement in the Ukraine and the Middle East, and as of mid-June, we’re still waiting to see who will blink first in Greece’s standoff with the European Union.
Against this backdrop, US equity valuations continue to edge higher. Since bottoming in mid-2011, US equity valuations have risen steadily to the point that investors may want to revisit their approach to this asset class. Based upon a historical analysis of price-to-earnings (P/E) expansion cycles, Invesco PowerShares believes US equities may still have more room to run as valuations creep higher.
A few things to consider:
- There are few investment alternatives with real interest rates still negative at the front end of the yield curve.
- Companies still have many ways to unlock shareholder value, including share buybacks, spinoffs, mergers and acquisitions activity and returning capital through dividends.
- The US economy is continuing to gather strength, as evidenced by fewer initial jobless claims and the Institute for Supply Management PMI remaining above 50%, as of May 31, 2015
Equity investors still face risks, however. As depicted in the chart below, S&P 500 Index forward P/E ratios going back to the early 1990s show that, outside of the tech bubble of 1997-2000, valuations have approached previous peaks of ~18, with the current expansion ranking among the strongest in the last 25 years.
Consider a contrarian approach
Contrarian strategies are commonly thought of in the context of, the worse that things seem in the market, the better the opportunities for profit (As the old saying goes: “Buy when there’s blood in the streets.”). In the current market environment, however, a contrarian strategy offers investors the opportunity to go against the crowd by investing in companies that are out of favor, yet exhibit strong fundamentals and capital appreciation potential. This strategy can potentially find “hidden gems” in a market where valuations are being stretched.
One useful barometer of contrarian investing is the Dow Jones U.S. Contrarian Opportunities Index. This index is made up of out-of-favor companies with attractive valuation characteristics and growth potential. Since its inception in 2008, the Dow Jones U.S. Contrarian Opportunities Index has generated higher absolute and risk-adjusted returns than three broad benchmark indexes — on an annualized basis and since its inception.
Contrarian investors often make use of the forward price/earnings to growth (PEG) ratio, which values companies based not only on current earnings, but also on earnings growth projections. By examining the valuations of “down-and-out” companies, investors may see opportunity to unlock value and generate capital appreciation within their portfolios. The table below shows how undervalued the companies that make up the Dow Jones U.S. Contrarian Opportunities Index are relative to other well-known indices.
An ETF with a contrarian investment approach
Investors who are interested in exploring a contrarian approach can talk to their advisors about the PowerShares Contrarian Opportunities Portfolio (CNTR), a smart beta exchange-traded fund that provides exposure to the Dow Jones U.S. Contrarian Opportunities Index. By replicating this index, CNTR offers investors exposure to an objective, rules-based approach to contrarian investing. The fund and index are reconstituted semi-annually with companies that lag the broader market, but outrank peers based upon fundamentals-based and other qualitative criteria.
1 As measured by the S&P 500 Index from 3/31/2009 through 5/31/2015. Source: Bloomberg L.P., June 18, 2015. Past performance is not a guarantee of future results.