Martin Steward considers a contrarian strategy that is not afraid to go neutral when the market is not in contrarian mood

Alastair Mundy, head of contrarian investments at Investec Asset Management, is quoting the movie ‘A Few Good Men' at me because I observed that his UK equities portfolio doesn't look particularly ‘contrarian'. Its top 10 holdings include Royal Dutch Shell, GSK, HSBC, Signet Jewelers, Vodafone, Unilever and BAT; Signet, GSK, Unilever, BT and HSBC even rank among its top 15 overweights.

"I have to say to people: ‘I could give you the pure contrarian ideas but you just wouldn't be able to handle it on a 3-5 year view'," he says. "We are true believers in the contrarian philosophy for a multi-decade horizon, but we need to dampen the volatility for clients."
Investec does that in three ways. First, the portfolio can be neutral on any stock on which the team has no view. Second, it is constructed as a mix of ‘vintages' - the dates at which contrarian overweights were established in each stock.

Overweights are implemented only in stocks that screen for a 50% discount to their five-year peak price. They are then held until the gap between the price and Investec's estimate of fair value, based on normalised earnings, has closed. But that results in some ‘vintages' stretching back eight years or more.

"If you look at our portfolio today, they're not all contrarian - but they were when we bought them," Mundy explains. "Our Royal Dutch Shell overweight came in back in 2004 when they were telling lies about their reserves and the board was getting sacked, for example."

While the portfolio's estimated 3-5 year EPS growth is close to that of the index, its historical five-year EPS growth is a full eight percentage points less. A lot of this stuff really was trashy for a long time, but now it is set to generate growth.

Which brings us to the third way in which volatility is contained. If Mundy is going to hold a struggling business for that long, he always wants to be sure its balance sheet gives it the time and space to recover. "We are happy if we think that normalised profits might not recover until 2015, as long as the company is going to still be around to benefit," he says.

That explains the three percentage point underweight to utilities, which would certainly be a contrarian sector today, and the eight percentage point underweight in materials. It helps make sense of the nine percentage point underweight to financials, but also the fact that HSBC is its third-biggest holding.

"Bank balance sheets still look unstable, they are still excessively reliant on wholesale markets for funding," Mundy says. "HSBC has a good deposit base and that means a competitive advantage when the opportunity to grow loan books finally re-appears, but also higher margins than those available to banks paying wholesale money market rates."

It also explains why a contrarian portfolio was overweight healthcare by eight percentage points through 2011. "When we bought Glaxo in 2004 and AstraZeneca in 2005, everyone was worried about those ‘three Ps' - pricing, politics and patents," says Mundy. "But we saw very strong balance sheets, a dependable level of future earnings, and lots of scope for cost-cutting. We don't mind buying defensives that are out of favour."

Similarly, Unilever, the portfolio's oldest overweight, from 2003, had spent years being pushed to meet earnings expectations at any cost, sapping innovation and investment in its brands: "The lovely thing about Unilever was that no matter how badly it was managed the balance sheet was never in a mess."

So much for the great picks of yesteryear. Is the cellar being replenished? Not particularly. Of its top 15 overweights, 12 were implemented before 2009 and only one in 2011. The strategy's tracking error and beta have been lower than usual over the past two years and this is consistent with the fact that, while more concentrated than usual at about 30 stocks, that concentration is in fairly neutral positions in larger-cap names.

"Are we being cautious?" Mundy muses. "Using our metrics we can't find anything to buy, which suggests that the market is being incautious rather than that we are being particularly cautious. But it's true that Q4 2011 was tough, and January has been particularly tough - and if there's a new paradigm in profitability we could turn out to be badly wrong."

But it is worth remembering that this strategy really is ‘balanced' - that is how a ‘contrarian' has been so consistent across all the time horizons in the Mercer table. And this is where the one identifiable newer vintage comes into play - the 12 percentage point overweight to industrials. The one overweight established in 2011 was in CRH, the building materials specialist, and that theme runs through many of the overweights from 2008-10: housing giant Travis Perkins; builders' merchant Grafton Group; and construction products specialist Kingspan.

"Construction levels in the UK and Europe are extraordinarily low," Mundy reasons. "This is not a bet that we are coming out of recession at the moment, it's simply a recognition that, at some point, construction levels will have to rise significantly." But it also points to how "tight" the portfolio is, to use Mundy's term. He means both benchmark-neutral and well-diversified between cyclicals and defensives.

"We are underweight financials and materials, but if this cyclical value rally continues, our construction names should rally, too," he says. "Clearly there are people with more cyclical portfolios out there, but we remain balanced."