Contrarian Investing (Part II)


“Bull markets are born on pessimism,” he declared, they“grow on skepticism, mature on optimism, and die on euphoria.” –John Templeton

John Templeton paid attention to the emotion of the stock market. The first half of his philosophy was “The time of maximum pessimism is the best time to buy.” When everyone else was selling, he bought low during the Depression and in 1939 at the onset of World War II . . . and he made millions.

The second half of his philosophy was “the time of maximum optimism is the best time to sell.” He sold high during the boom when everyone else was still buying. Founded in the 1950s, his Templeton Growth Fund averaged 13.8% annual returns between 1954 and 2004, consistently beating the S&P 500.

I think there are a few ways to make many times (10x to 100x +) your money over a long period of time.   The first would be to own emerging growth companies that have owner-operators who are both excellent operators and capital allocators who grow the company profitably at a high rate over decades.   The business generates high returns on capital while being able to deploy capital into further growth. Think of owning Wal-Mart in the early 1970s or Amazon after its IPO or 2001.   There will be a post on 100 to 1 baggers soon. I prefer this approach.

Wal-Mart 50 Year Chart_SRC

The second way would be to buy distressed assets and then improve those assets or create efficiencies by creating economies of scale. Carlos Slim, Mexican Billionaire, would be an example of this type of investor. Think activist investing. Note that Carlos Slim has operated at times as a monopolist in a government protected market.  Most of us do not have his options.

The third way would be to buy deeply-distressed, out of favor, cyclical assets and then resell upon the top of the next cycle. Gold mining is a difficult, boom/bust business, for example–see Barrons Gold Mining Index below. All businesses are somewhat cyclical, but commodity producers are hugely cyclical with long multi-year cycles due to the nature of mining-it takes years and high expense to reopen a mine and even if I gave you $2 billion and several years, you and your expert team may not be able to find an economic deposit. Note the five-to-ten year cycles below.

gold mining bgmi

We are focusing on the third way, but in no way do I suggest that this is for you. You need to be your own judge.  There is a big catch in this approach, you need to choose quality assets and/or companies with managements that do not over-leverage their firms during good times or overpay for acquisitions during the booms (or you could choose leveraged firms but be aware of the added risk and size accordingly becasue when a turn occurs, the leveraged firms rise the most). You also need to seek out a period of MAXIMUM pessimism which is difficult to do. How do you know that the market has FULLY discounted the bad news?  Finally, YOU must be prepared to invest with a five-to-ten year horizon while expecting declines of over 50%. That concept alone will make you unique.   Probably most will turn away from such requirements.

We pick up from  Before we delve into the technical aspects of valuing cyclical companies, think about what it FEELS like to have the CONVICTION.  Here is an example:

We last studied Dave Iben, a global contrarian investor, in this post:   You should read, Its Still Rock and Roll To Me at and listen to the last few conference calls at the right side of the web-page.   Note Mr. Iben’s philosophy, approach, and Holdings. His portfolio is vastly different than most money managers or indexers. But being an contrarian takes fortitude and patience. Kopernik Global performance since inception:

koper spy

Next preview the readings below.

First you need to understand Austrian Business Cycle Theory to grasp how massive mal-investment occurs. Why does China have newly built ghost cities? Distortion of interest rates causes mal-investment (the boom) then the inevitable correction because the boom was not financed out of real savings.

Why is the bust so severe for mining/commodity producers?   Read Skousen’s book on the structure of production.  Think of a swing fifty feet off the ground and 200 feet long.   If you are sitting near the center of the swing’s fulcrum (nearest the consumer), then the ups and downs are much less than being on the end of the swing furthest from the consumer (the miners and commodity producers).

4 files were sent to you.
Read Ch. 19 Security Analysis.pdf
Boom/Bust Austrian business cycle theory.pdf
Damodaran Valuing Cyclical Commodity Companies.pdf
Must Read Structure-production.pdf

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Even if you are an expert in valuation, investing in a cyclical company can be lethal: Vale: Go Where it is darkest (Damodaran)

ValeBig Vale

Then Throwing in the towel on Vale. I am not picking on Prof. Damordaran because we all make mistakes, and he graciously has provided a case study for us.  Study the posts and the comments.

Can you think of several research errors he made (BEFORE) he invested?

Remember in the prior post, the long-term chart of the CRB index showing commodities at 41-year lows since the CRB Index is below 175 or back to 1975 prices?  Then why, if gold is a commodity,  doesn’t gold trade at $200 or at least down to $500 to $700 as the gold chart from that time shows?monthly_dollar

Why, if gold is money, doesn’t gold trade in US Dollars at $15,000 or the estimated price to back US Dollars by 100% in gold?  You can change the amount to $10,000 or $20,000, but you get the monetary base


Gold during the boom of 1980 rel. to Financial Assets in 1980 the price of gold at $800 per ounce allowed for the US gold holdings to back each US dollar then outstanding.

Try thinking through those questions.  Can we use what we learned from gold to value oil?

I will continue with Part III once readers have had several days to digest the readings and at least three readers try to answer at least one question.  Until then……………………….be a contrarian not contrary.

Update on 21/Dec. 2015

19 responses to “Contrarian Investing (Part II)

  1. “Then why, if gold is a commodity, doesn’t gold trade at $200 or at least down to $500 to $700 as the gold chart from that time shows?”

    Unlike most other commodities where the demand increases in good economic times because they are ultimately consumed, gold is mostly used for investment purposes, and its demand is negatively correlated to how good the state of the economy is perceived to be.

    “Why, if gold is money, doesn’t gold trade in US Dollars at $15,000 or the estimated price to back US Dollars by 100% in gold? You can change the amount to $10,000 or $20,000, but you get the idea.”

    The velocity of money has not increased enough.

    • I agree that gold is not consumed. All the gold ever found is still in existence.
      How is gold an investment? Gold creates no cash flow unless you lend it out, wealth can’t be created with gold. It just sits there in a vault. How do you define an investment?

      So you are saying that the demand for gold rises when the economy is perceived as bad? Any evidence that you can share? Gold rose from 2002 to 2011 while the US came out of the 2001 and 2009 recessions.

      What is the velocity of money and how does it have any effect on gold or prices of goods? We have ten sea-shells used as money to be used in exchange for the two goods produced on the island–fish and coconuts. Today four shells for a fish and one shell for a coconut. There are six coconuts available. Tomorrow, one shell fetches two coconuts because of a wind storm knocked a lot of coconuts off the trees–supply rose. So the next day we have four shells for a fish and six shells for 12 coconuts. The value of the shells is increasing due to the increase in goods supply. But what if the “velocity of money” skyrockets and the islanders sell coconuts for shells then buy fish, then increase their level of exchanges–what difference? Prices and goods would remain the same just the frequency of exchanges would increase.

  2. And I agree that the ability to handle absurd amounts of volatility is the key to successful investing. It’s an ability that can’t be learned from scratch though. It won’t take long to realize whether or not you have it. Let’s say you own a stock that goes down over 90%. Your analysis shows that the original reason you bought it is no longer present, and no other good reason has replaced it. If you are able to sell it without getting sick to your stomach and can come back to look at that company from time to time, then you probably have it.

    • I don’t k now what you mean by “absurd” When the price of gold moves from $1070 to $1030 or only by $40 or 0.4% the producer who has an all-in sustaining cost of $1,000 and vast reserves can see the value of the firm swing by 5% to 10% (because the miner’s profit margin fell from $70 down to $30 or over 50%!) or more depending upon the expectations of investors.

      The more you understand the industry and your companies the better knowledge you have to maintain your emotional equilibrium.

      • Absurd stock price volatility by most people’s standards, not objectively absurd. I’m talking about stocks in general, not about gold stocks.

  3. Gold isn’t money. Gold is a shiny yellow metal that was used as money in the past. Today, its price fluctuates based on the whims of financial markets. It has relatively small demand in the real world in jewelry and some industrial uses. Supply is largely constant. Thus its price movements have almost no direct driver from real world fundamentals. Indirect drivers, yes, as prices will move based on traders’ beliefs of how other traders will view said fundamentals, or traders’ myriad beliefs of how gold prices “should” relate to fundamentals. But unlike stocks, whose true values are realized through real-world interfaces like dividends, stock buybacks, and acquisitions, theories on gold are never proven as they have no real-world interfaces. Due to these characteristics, gold is probably one of the better instruments for speculation. Unlike many other speculative instruments, gold wont go bankrupt, be diluted away, expire, liquidate, etc. and doesn’t have massively negative long-term expected value as its price has kept up with inflation.

    • While gold is certainly not used as a currency because one can’t plunk down gold nuggets to buy candy, why then do central banks buy tons of gold? Why not coal or iron ore. And why even bother with gold if all money is FIAT money anyway?

      Why has gold kept up with “inflation?” What is inflation? Are rising financial markets a sign of inflation? Why or why not.

      So speculation is keeping gold two to four times above its US dollar price of 40 years ago?

      If countries are becoming more productive then why are prices in general NOT continually falling–like say personal computers?

      Thanks for posting.

      • The fact that central banks trade and hold gold doesn’t make it money. The reason, I’m guessing, is partly influenced by the past, when gold used to back their currency and so central banks necessarily needed to hold gold. They were obligated to exchange cash for gold if requested and thus it did have a real-world interface. Not true today but they likely still see it as an asset that will more or less hold its value. They could hold bonds, stocks, rare art, etc. but it does not make them money either.

        Central banks dont hold iron ore or coal because they aren’t as good at holding value. Supply and demand are constantly changing. At least gold’s supply stays stable and its demand isnt directly tied to economic strength. Also it would take up a ton of space and be really inconvenient, since you need a lot more iron and coal (physically) to have equivalent value to gold, because they are much more common elements in the earth’s crust.

        As for why gold has kept up with inflation, like any asset the price is determined by supply and demand. On the supply side, it’s not increasing much. On the demand side, it fluctuates wildly based on investor/trader sentiment but over the long term it’s always held some appeal as an asset. Any object with similar properties – constant supply, rare, some aesthetic appeal, long-lasting, etc. – can also keep up with inflation. For example, rare art, antiques, other rare metals like silver and platinum, whatever. But just because gold’s price has kept up with inflation, nothing says it must keep pace with inflation in the future. It’s possible gold permanently loses investment appeal in the future and its price stops keeping up with inflation. Not that I would bet on that happening but like you said, anything is possible. We could find a huge gold deposit on another planet. Or maybe in the interstellar economies of the future, the physical nature of gold becomes wholly impractical due to distances between stars, and it becomes obsolete as a store of value.

        Don’t want to argue the definition of inflation. I am using it as it’s commonly used. Might not conform to your definition but you know what I mean. Why are prices not continually falling? Because there’s inflation. Personal computer prices fall quickly because they are increasing in quality at a faster rate than most other things. A computer that was good fifteen years ago would be unbearably slow today but the same isn’t true for a barrel of oil, a car, a house, etc.

        • OK, the high stock to flow ratio makes gold unique and a choice for people to store value or hold value until gold can be exchanged for currency. For example, I bought more CEF yesterday rather than hold certain stocks.

          Thanks for replying

          Since the fiat currency regime has been in existence only about 50 years, does anyone think the system will last another 50 years?

  4. I actually think Vale will be ok. I still remind myself of the Pabrai rule, hold for 3 years, then revisit whethere or not earnings potential is permanently impaired or intrinsic value is much lower.

  5. Why do you think Vale will survive?

  6. When price is below the costs or production, you’re going to get the usual supply/demand adjustments, lower prices cure for lower prices etc. If Vale survives long enough even at losses (without defaulting on debt or some political risk), it really doesn’t matter how low the price in the shares go, when the commodity price recovers (could be years, but the faster commodity prices fall, the faster the rebound) due to supply adjustments, then Vale will increase its intrinsic value. Kopernik reports also states the case of price of commodities being less than incentives to mine (in the case of gold) which obviously is going to apply to iron ore just the same.

    I also remember that exercise you gave us months ago in your blog about earnings being halved, then halved again etc for 3 years and the 10 year return when earnings recover what the intrinsic value.

    All these things look ripe for mean reversion, which seems to be a key skill in deep value investing.

    I have learnt from this blog that nobody knows when the bottom of a cycle is, but value investors are paid to catch knives and provide liquidity for longer periods than the normal psychology of markets.

  7. “About this time tomorrow, a seah of the finest flour will sell for a shekel and two seahs of barley for a shekel at the gate of Samaria.” The officer on whose arm the king was leaning said to the man of God, “Look, even if the Lord should open the floodgates of the heavens, could this happen?” “You will see it with your own eyes,” answered Elisha, “but you will not eat any of it!” “- 2 King 7:1-2

  8. Good answer. Thanks.

  9. Can you think of several research errors [Prof. Damordaran] made (BEFORE) he invested?

    The thing that stood out to me for Prof. Damordaran’s first analysis is that he assumed Vale’s earnings had already bottomed out. And he added 2% annual growth on that hypothetical bottom.

    He did not look beyond the last 5 years to see what happened at the last bust in the cycle. (Nor have I, but I bet ROIC was less than 11%.)

    And he did not look at the direct the company was headed each quarter. Nor have I, but I bet they show a situation getting progressively worse.

    I also think he assumed too low a cost for Vale’s debt.

  10. Hi John, the Security Analysis and Business Valuation on Wall Street file is actually essays of warren buffett.

  11. Hightail has become rather slow these days. I sometimes use Binfer for certain clients who are leery of cloud security. Learn about serverless file sharing

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