ft: be contrary and boldly back uranium miners

Financial Times
SMART MONEY April 30, 2014

Be contrary and boldly back uranium miners
By John Authers

Aggressive value investing demands an iron constitution

Here is a test of whether your latest stock pick is a good idea. Does it inspire a sharp intake of breath? Or a stifled guffaw? If so, you should probably buy it.

That is the philosophy behind the mutual funds run by Joe Huber, a contrarian whose portfolios include Hewlett-Packard, Bank of America, Herbalife and various uranium miners.

SMART MONEY

All are likely to produce a sharp intake of breath. Hear the word “Herbalife” and the chances are you think of the campaign being waged against the company by the hedge fund manager Bill Ackman. Hewlett-Packard and Bank of America tend to bring up recent deals already written off as disastrous, involving Autonomy and Merrill Lynch. As for uranium mines, the word that comes to mind is “Fukushima”.

But this is their appeal. If instinctive reactions to these names are so negative, the chances are they are too negative, and will stay negative too long. This borrows from the psychological insights of behavioural finance, where this effect is known as the “availability heuristic”. We latch on to the most recent, most pressing piece of information available, even if it is not relevant for the future.

Aggressive contrarianism has deep roots. A form of value investing, it is perhaps most closely associated with the Canadian investor David Dreman who has written pioneering books on applying psychology and logged impressive performance with tightly concentrated portfolios.
It also has drawbacks. Performance during market panics can be painfully bad and require more patience than investors can muster. In April 2009, at the bottom of the sell-off that followed the implosion of Lehman Brothers, Mr Dreman was fired as the manager of a mutual fund he had managed for 20 years by Deutsche Asset Management. At the time the fund had lost 47 per cent over the previous year and was loaded with financial stocks.
Mr Dreman’s contrarianism flourishes in the longer term. Financial stocks rallied dramatically after early 2009. Over the past 10 years, Dreman funds, still loaded with financials, are comfortably ahead of their benchmarks.

Long time horizons

However, such contrarianism differs from other kinds of value investing. Warren Buffett, for example, looks for the rare companies that have a “wide economic moat”, meaning they can defend high profit margins. Companies such as Coca-Cola, one of his favourites, have never been radically out of favour.

What are the arguments for aggressive contrarianism? Mr Huber’s new insight is that the availability heuristic grows most useful when combined with a finding derived from a careful examination of company accounts over time. This showed that companies’ return on equity, or profitability, has an overwhelming tendency to revert to the mean over time. A company’s profitability today proves to be literally irrelevant when predicting its profitability in 16 years’ time.

Thanks to the availability heuristic, however, investors assume that today’s lousy profitability will continue into the indefinite future. That creates an opportunity for contrarians with long time horizons – and nerves of steel.

Rather than look for companies with a low price/earnings multiple, then, Mr Huber looks for companies whose performance is suffering – but that have a good chance to bring their profitability back up to the norm ahead of schedule.

Activist battleground

This leads to uranium miners. The Solura index, covering the largest producers, is still down about 77 per cent from just before the Fukushima nuclear accident in early 2011. As a group, uranium miners are scarcely above their lows during the crisis year of 2008.

But Mr Huber suggests that this is the availability heuristic at work. He believes uranium demand should rise 50 per cent in the next decade, as developing countries such as India, China and Vietnam adopt nuclear power. Military sources for filling the shortfall are limited, as the destocking of military uranium is largely over. Meanwhile, with uranium prices low, production is also low. This turns into an argument to buy uranium producers.

Another startling name is Herbalife, which Mr Ackman alleges is involved in “pyramid selling”. Herbalife has turned into a battleground for different activist investors, rallying last year, and then falling this year after news of a civil probe. This month the FT reported that Herbalife was also the subject of a criminal investigation, which may not lead to charges, forcing the stock down further.

Why is Mr Huber sticking with the stock? He has done due diligence, including sitting in on sales calls. He found that the meetings were geared towards targeting consumers, and not other distributors, as a pyramid scheme would do. He is also confident that the terrible publicity around the company will not affect its cash flows – customers see the branded products, not the name of the company itself, and its typical customers tend to be unaware of the stock market.

Whether or not he is right, holding Herbalife requires an iron constitution. But that is the cost of contrarian investing. So far the Huber funds, in operation since 2007, are comfortably ahead of both general and value indices. This is not a style that many will want to copy – and that, in the long run, is the crucial advantage of contrarian investors.

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