The DNA of a bona fide contrarian

"As soon as you start to get comfortable in a particular stock or company, we're generally selling and finding the next uncomfortable thing to own." That’s the contrarian nature that exists at Allan Gray and is reinforced by their fund managers. In the latest installment of our Fund Manager Q&A, we sat down with Dr. Suhas Nayak, Portfolio Manager and Analyst at Allan Gray, to discuss how he goes about making his life as uncomfortable as possible, the one sector that will be a contrarian's dream in three years' time, and what it was like going to school with Livewire co-founder James Marlay.

Q: If we were at a dinner party and someone asked “What is it that you do?”, how would you answer? What would be your pet topic later in the night we would find you talking about?

I think I'd describe my job as trying to find good investment opportunities in unloved parts of the market. It sounds simple to say, but it's more difficult to do.

At this moment, I think the thing that we find fascinating is the disparity in valuation between growth stocks and cyclical stocks. Growth stocks are getting bid up, things with growing earning streams, certain earning streams, are really in favour. And anything with a whiff of uncertainty is just being discounted a lot.

We are obviously finding opportunities in the cyclical stocks, but we do find it interesting how the market discounts uncertain growth. They say that the growth is uncertain and then they add risk weights and higher discount factors et cetera to the point where uncertain growth essentially gets no credit whatsoever. And I just find that interesting compared to, you know, other stocks that might have more volatile earning streams.

Q: You started your career in consulting at McKinsey. What do you think were some of the lessons, some of the skills that you've carried over into your role at Allan Gray?

Before McKinsey, I was a mathematician. I was doing graduate studies in mathematics and it would be fair to say I had no idea how companies worked. Management consulting is a great training ground, and it gives you great exposure to how companies work on the inside. How management tick, what makes them tick. What are the sorts of things that can prevent them from making good long-term decisions. And I think those are good perspectives to have when you transition over to an investing-type role.

Q: Did you have any mentors or heroes in the investing space?

I think the value style had piqued my interest even before joining here, but since joining it's really been observing, or taking inspiration from contrarian investors. That's really inspired me.

One of my investing heroes would certainly be Simon Marais who founded Allan Gray in Australia. 

Understanding that you don't have to be right all the time, and the only way to get something at a good price is when no one wants it. I think those are pretty good lessons.

He once said, and I can only paraphrase these things, but it was basically when you are buying stocks that are disliked or hated, "awful" is often priced in, an awful outcome for that stock is often priced in, and things only just have to be bad, and it could be a great investment. But when things are really loved, then extremely good outcomes can be priced in. And even if those outcomes end up being just good, it could be a poor investment. It really is about what expectations are priced in.

Q: When we spoke recently with Simon Mawhinney, he said there's not a single stock in the portfolio that makes him feel comfortable. Is that a hard thing to wrap your head around coming into this industry?

It's very difficult from an emotional perspective because as soon as you start to get comfortable in a particular stock or company, we're generally selling and finding the next uncomfortable thing to own. And so it's a constant juggling act, in terms of trying to find the next really uncomfortable thing. That's difficult, but I think that's where the opportunity is as well.

Q: So you've gone out to make your life as uncomfortable as possible?

It's not doing much for my hair!

Q: You went to school with one of our co-founders, James Marlay. Did you get a preview of the fintech entrepreneur you see today, or was he more likely to be found disrupting the incumbents on the rugby pitch?

My earliest memory of James is playing cricket with him. We were on the same team for one or two years, and he was a good batsman, I was not. So that's my earliest memory. But I think it would be fair to say that at school, we were all Luddites, so ... you know, finding James in a technology-inspired financial services business is a nice, surprising departure.

Q: So he wasn’t much of a trouble maker?

I'm trying to recollect. Normally the trouble makers were the ones called out in assembly, and do I recall James being called out in assembly? Probably once or twice. But definitely not on a consistent basis.

Q: Let’s take a look at your initial process. Can you walk us through how you research potential holdings? What are some of the screens that you go through?

The screening starts off quite simply. We essentially just look for companies that have done badly, or that are getting a lot of attention for all the wrong reasons. Their prospects are pretty bleak, everyone's writing about them saying that they have a terrible future ahead of them. That's normally what piques our interest.

We'll start researching the company at that point and we spend a few weeks trying to understand how the company makes money. Again, it's a simple thing to say but really understanding what drives earnings is something we spend a lot of time trying to figure out. We do that by looking at as many financial statements that we can possibly get a hold of on the company, on its peers, on its customers, on its suppliers, and we'll try and build out a picture of where they sit and what earnings have looked like in the past, and what has driven those earnings.

That can take a few weeks, and if at the end of that we think that price compensates for the risk we take in investing in the company, then we might write it up and send it out to our investment team, at which point there is a discussion in the investment team around the company.

We spend most of that discussion trying to rip the thesis apart and trying to understand where it would fall down and why. 

We will then make a decision as to whether to invest in the company or not at that point.

The big filter is: Does it get presented to the investment committee? We don't have that many ideas come through to the investment committee in any given year but we do comb through a lot of stocks individually. Probably about a third of the things that come to the investment committee would get invested in.

Q: How long does a company have to be in the headlines to get on your radar?

I don't think there's a hard and fast rule. Our best investments are often companies that have done badly for a while, and the market has just forgotten about them, or written them off, or there are still some negative headlines coming, but a lot of the expectations around the company have been re-based to something pretty poor. And the best investments are often companies that halve after we first invest. Those tend to be the best investments for the fund.

Q: Are there any companies where you just say, “That’s too bad, even for us”?

That really depends on the price and what "that bad" is. I don't know if we would ever say no to anything. There's no hard and fast rule. We do believe there's a price for everything, but sometimes that price is zero.

Q: Could you take us through one of the current holdings in the portfolio?

So this is not one that I put in there, but I thought we could talk about Oil Search. We started investing in Oil Search around the time that oil markets had recovered a little bit, but there was still a reasonable amount of pessimism around future oil prices. We had already invested in a few oil and gas stocks, so various people in the team had looked at what it really costs to produce a barrel of oil, across a number of different industry players, to try and work out what the cost curve of oil production looks like.

When we started looking at Oil Search, we were trying to figure out what oil price was being priced in by the market and it seemed like a reasonably poor outlook for oil was being factored into the Oil Search share price, so it was around that time that we started buying.

More recently there have been concerns around future growth. Oil Search had been the oil stock darling in a way, because of all the growth that was ahead of them, and more recently there's been some scepticism around when that growth might come about, and so, again there's been a reason to look at them again and add to our holdings.

We like it a lot when there is growth that isn't being priced in, in that you're not paying for it. And even better when you're not paying for that growth, or for higher oil prices. I think that could be a good investment for the future.

Q: So you're quite bullish on oil, then?

I wouldn't say bullish, we just think that a lot of oil industry players would find it hard to maintain production at current levels, with oil prices much below where we are today.

Q: One of the sectors that looks like a contrarian's dream at the moment is the retail sector. Are you seeing any opportunities in that space?

We've definitely got our eye on the retail sector. I don't think we're invested in any discretionary retail-type stocks at the moment. But again, there's a price for all of this. We just haven't seen that price yet.

I think the concern has always been, “What does bad look like in retail”? And because we've had this 20 to 30 years of growth in our domestic economy, we haven't really seen what bad would look like. And retailers' business models are incredibly operationally leveraged. Even a small drop in sales could really impact profits, and they have to run quite hard in terms of growth just to stay still in profits, because there's this natural inflation that happens in rent, labour, et cetera. You want to buy these stocks reasonably cheaply, we just haven't had that opportunity.

Q: Can you talk about a time when you have invested in the retail sector?

We've been a previous owner of David Jones, a few years ago before the takeover. We had thought that the price was assuming a rather bleak outcome, just like many of our investments. But at the time, David Jones had a couple of properties here, and so we thought there was a backstop, in a way, in terms of how bad the investment could be. Because at some point, people would snap up the properties. Even if the retailing business itself was not sustainable. So we saw some upside, but not a lot of downside, and that's why we invested. The takeover helped, obviously, because I think conditions had been probably worse than we would have assumed at the time. In hindsight, it would be fair to say we were quite lucky given what has transpired there.

Q: Is there an area of the market that you think investors have got a bit carried away with, that in three to five year's time will come across your desk as a massive contrarian opportunity?

We would love the opportunity in three to five years' time to invest in a few healthcare stocks, but we haven't had that opportunity to date. There are some great companies in there, but the price has never been something that had interested us.

We're not clairvoyant, we have no idea about when these things will turn, if at all. Some of these stocks have done very well and we've just not been exposed to them. It would be nice to have the opportunity to have some of that exposure in the future. Just not at these prices. But I should say that we don’t think about exposure to particular sectors because we invest in individual companies and build the portfolio bottom-up. 

Q: What was the last book, podcast, or report that made a big impression on you?

I listen to This American Life, it's a podcast about just ordinary Americans and their stories. I find that often quite fascinating.

The Prize, by Daniel Yergin, you know, while we were investing in oil and gas stocks, that was a nice companion to have, just to look at the long history of oil and gas, which was very interesting.

More recently I've read this book called How Not to Be Wrong, by Jordan Ellenberg. It talks a lot about the pitfalls of drawing inferences from data. Unfortunately, I'm, still wrong a lot, but ... it's a good book to read. I think there are some good lessons in there. If you look at statistics, what can you meaningfully say from them? I think there are some really great anecdotes and lessons to keep in mind.

One that springs to mind is an anecdote about World War II. They had these people trying to figure out what to do about aeroplanes that were being hit by German guns. And they had all these planes come back, and they'd look at where all the holes were being found, and they would think about whether they should put more protective covering here or there.

But some clever guy realised that actually they had a very biased sample set, because they weren't seeing any of the planes that had actually crashed. And the ones that had crashed were the ones where the bullet holes were penetrating the engine block, not the ones hitting the wings, or the tail, or whatever. The real protective covering should have been on the engine. And all this analysis of how to protect other parts of the aeroplane didn't really help. Even though you were analysing actual data, the data was biased. So I think that's kind of interesting.

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