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Gal^Stad
Investments Inc.

spacer January 2004
Commentary

Ottawa Citizen: A Case Study in the Contrarian Approach

Every once in a while a new subscriber e-mails a question along the lines of "I have xxx dollars in cash, want to start a contrarian portfolio, and don't know how to get started. What do you suggest?" As we are not investment advisers or financial planners, it is a query we steer clear of.

But since we do take our role as educators seriously, we thought it might be helpful to look at a specific case in which we have applied our methodology to a situation that is a little bit different from our normal day-to-day dealings with the Contra portfolio.

In October 2002, Keith Woolhouse of the Ottawa Citizen asked Contra the Heard to participate in a series of articles designed to showcase different approaches to managing a hypothetical portfolio of $50,000. Joanne Livingston of Scotia McLeod and Noral Rebin of CIBC Wood Gundy also agreed to take part.

Starting off with a clean slate is an interesting exercise. Off the top, the Contra Guys decided to limit ourselves to stock selections only. Yes, asset allocation is important, as Ms. Livingston pointed out, and diversifying over a number of asset classes makes sense.

But Contra is focused on stocks, so they became our focal point. Also, in our view, asset allocation is a highly personal decision based on a myriad of factors -- not only age and income, but also the size of your stash, your appetite for risk, penchant for action, and so on. It is futile to pretend that one size fits all.

Our first step was to base this model portfolio on our 1-4 Purchase Weighting System. We reckoned that a roster with a maximum of six or seven picks would do, meaning that a moderate weighting of 2.5 would be equivalent to about $7,500, the minimum of 1 would be worth $3,000 and the maximum of 4 would be pegged at $12,000.

Why not branch out into more stocks? As important as diversification is to control overall risk, its benefit drops off sharply once there are already a number of eggs in the basket. After a certain point, the effects of overdiversification take hold, meaning that the smartest bets no longer have sufficient weight to turbo-boost the returns.

We were asked to provide our initial selection of companies on October 25, though the "competition" wouldn't start until the closing prices on October 31 were in. That forced a departure from our usual method of placing limit bid orders on stocks and waiting for the market to come to Poppa. It meant we paid more than was allocated for some positions; for example, KLM was at $10.09 on the 25th, but $11.56 on Hallowe'en, a 14.6 percent premium. Ouch!

The starting portfolio looked like this:

StockSharesPriceAmount
JEQ900$ 4.15$4,930.20
KTI16,000$ 0.56$8,960.00
KLM400$ 11.56$6,103.68
SOD5,500$ 1.50$8,250.00
Cash$21,756.12

Why, out of the 13 entries listed as Buys in the October 2002 issue, did we choose these four favourites? A key consideration was our conviction that the USD was overvalued; as we were leery of American stocks, Japan Equity Fund and KLM were offered as examples of how to play this currency risk. Even though both equities trade on the NYSE, their prices are tied to the yen and euro respectively.

Further, the choices of Japan and an airline would leave no doubt about our contrarian credentials. Sodisco-Howden was a case in point of a company that was improving itself methodically but, as is often the case, was slow to receive its due from Mr. Market.

Finally, though it was less obvious at the time, our assessment was that President Bush would get his war, so some exposure to the petroleum field made sense, and Kelman was our only candidate. It was also nice to have a penny play in the fold.

These picks certainly set us apart from our two competitors, but the most drastic difference was that we held back almost $22,000 in cash, or a whopping 43.5 percent of our total stake; Livingston and Rebin, by contrast, held back little. The pros treat cash like a chicken salad sandwich on a hot day in July -- something to be consumed quickly, before the bacteria ravages.

Our rationale, on the other hand, is completely different. We see investing as a hunt for a wily quarry, and cash in the hand is our quiver of arrows. Fire them all off in one big volley at the first movement in the bushes and you had better hope you've hit something good, because you have run out of ammo.

While Rebin has gone to great pains to portray his style as "conservative," our version of conservatism is to save cash for timely, propitious strikes.

In December, we added two stocks: Corriente and Stelco. These were true to our "Made in Canada" philosophy and added copper and steel to the mix. Corriente was interesting in light of all of the folks who recently expressed their fears about not getting into our stocks quickly at a good price.

We bought Corriente in July 2002 at 86 cents, and it immediately improved smartly to a buck, yet we were able to add it to the Citizen portfolio five months later at 75 cents. This sort of pattern isn't unusual at all: we have yet to see one of our selections move in a straight line upwards to the sell target.

Even if stock prices follow a distinct trend over time, they meander and dip along the way. With patience, it's often possible to catch the fish that seemed already fried.

It may strike some as odd that we did not add either of our promising December tech stocks, Novell or Network Equipment. That is because we make it a policy not to discuss our picks with anyone except our subscribers for 30 days after our purchase. This is to allow our readers sufficient time to study and perform due diligence before too much attention is drawn to the selections.

This is a rule we would ask you all to adopt. We were none too pleased to see word of a recent purchase show up on a Yahoo message board a mere two days after we made it. This no doubt contributed to the extreme price spike in the stock.

Of course, there is nothing wrong with bragging about your investing prowess; indeed, bringing the story of a turnaround to a wider audience is part of what turns an out-of-favour stock into a popular one. Just keep it zipped for the first while, and gab about it later.

Oh, yes: sometimes we find out about people forwarding e-mails; we tell the naughty parties that their subscriptions will not be renewed. That copyright thing.

When the "cooling-off" period elapsed at the end of January, we added Corel to insert a bit of tech. As it turned out, better choices were to be found, but it was hard not to go with the "home team" in an Ottawa paper.

That purchase completed our little portfolio, and it is amazing how much ground those seven stocks covered: the Japanese heartland, airlines, hardware, copper, steel, software, and oil and gas exploration. It also covered the angles on three currencies and had a pleasant mix of firms with large and small capitalizations.

No sooner was this tidy package put to bed than the gremlins came out to play. The advent of SARS in Asia trashed KLM. The Japanese bear pushed the Nikkei to 17-year lows. And after a nice rally in January petered out, Stelco swooned.

To make matters worse, as the overall market improved in spring, our stocks wallowed in the mud, down 8.7 percent in June versus positive tallies of 6.1 percent for Rebin and 5.1 percent for Livingston.

As we have seen many times over the years, it is at the very moment when a portfolio looks grim and bedraggled that it is actually in superb shape and ready to spring. And that is exactly what happened.

Stelco got the boot at $1.10, but otherwise it was clear sailing. Corel was cashed out, two-thirds of the Corriente was sold, and the great grey Hudson's Bay Company was added. At the one-year mark the portfolio was valued at $72,375, an increase of 44.8 percent over the initial value of $50,000.

A critic might say this was a lucky outing based on risky, speculative stocks that happened to pan out, and with a monthly volatility that would repel most investors. Not to make a straw man here, but these are all points that are important, yet they miss the mark.

Yes, we were fortunate to ride the strong wave of a small-cap revival, but that doesn't account for KLM, JEQ or HBC. Corel, while positive, was bought by Vector for a price that seems laughable now. And with the Contra portfolio sporting a gaudy won-lost record of 24-1, it was a lousy break to pick Stelco. Lady Luck could have been more generous.

As for risk, it depends on how one assesses it. Mr. Rebin, who implements his "simple and conservative" style by sticking to well-known Canadian companies, nonetheless chose Bombardier, an outfit that veered off track to the tune of 43 percent at one point.

Hey, stuff happens; last year's stable blue chip can easily be this year's flameout. Our Laidlaw scar still throbs whenever Lord Voldemort is on the prowl. Regardless of which system you use to avoid trouble, there will be setbacks. Diversification is a crucial defence, but so is the habit of choosing stocks with enough upside to offset failures.

We aren't proud of the way Stelco, whose ups and downs thoroughly bamboozled us, was played, but we are pleased that the winners have been productive enough to neutralize our boneheaded moves.

As for the volatility of this portfolio, we make no apology. The popular notion that volatility is an indicator of risk is complete hogwash. Whether a portfolio is up or down, and by how much, in any given month only matters in two circumstances: if you might need the money for living expenses, or if the mere thought of paper losses and gains turns you into a bipolar wingnut. In the first case, you shouldn't be in the stock market; in the second, well ... it depends on how much you enjoy stress. Investing shouldn't resemble a Don Cherry play-by-play commentary of a scrap -- "Left hand ... right hand ... look, Domi is recovering and pounding him now!"

In fact, if there is one major downside to a series like the one in the Citizen, it is that the articles tend to reinforce the notion that a monthly performance assessment is significant, when even a year is nothing more than a blip in the sands of investment time.

There are lots of methodologies that can work; it is a matter of finding one that matches your personal means, responsibilities, temperament, time frame, and so forth. And, as we hope this exercise has shown, one doesn't have to follow a system to the letter to get decent results. We chose a subset of our portfolio, and selected the stocks well after they had been purchased for Contra -- some at higher prices, others lower.

We took some liberties with our weightings, and were fully invested for only three months out of 12. The final result differs from our official tally, but it is well within the ballpark.

Looking ahead, we'll ride the core stocks and add a couple more when the timing seems reasonable. Now that the capital base is much larger, the roster can be expanded a bit.

If some of you see yourselves in the mirror in this description, that is no accident; the goal of this commentary was to directly answer your questions. At Contra, we listen.

For more on the Citizen experiment, click here.

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