In the world of investing, if you run with the herd, the herd is the market — and the investment return of the market is about the best you can hope for. There’s nothing wrong with that, but buying a cheap FTSE 100 tracker is the easiest way to do it!
If you aspire to make a better return than the market, you have to go against the grain to some degree. That means investing in at least some companies that are out of favour. Such companies are higher risk — or are perceived to be higher risk — but have the potential for superior rewards.
Making a contrarian investment can be uncomfortable. In the short term — even the medium term — unloved companies can remain unloved, or fall still further out of favour with the market. But many out-of-favour stocks come good in the long run.
Right now, Rio Tinto (LSE: RIO) (NYSE: RIO.US), Standard Chartered (LSE: STAN) and Wm Morrison Supermarkets (LSE: MRW) are some of the most deeply unfashionable stocks in the FTSE 100.
Rio Tinto
The shares of mining giant Rio Tinto made an all-time high of around £70 in the summer of 2008. After the market crash, they climbed back to £45 in 2011, but have since been in decline, and are currently trading near to £25.
Oversupply has taken its toll on miners’ profits and concerns about China’s economy have worn away at investor sentiment towards the industry. But Rio is a top-class business. And, as one of the world’s lowest-cost producers of iron ore — at not much more than $30 a tonne — the company can still make a profit at prices of $40 or even sub-$40 that some analysts are predicting. At those sorts of prices, many rivals would be plunged into losses.
Rio acknowledges that the iron ore price went to “an unprecedented high that was never sustainable”, so we’re not going to see the company’s shares as high as £70 again for many years. But we don’t need to. There’s still the potential for very strong gains, because the current share price is so depressed. Rio’s forecast price-to-earnings (P/E) ratio is an encouraging 15, while the prospective yield is a whopping 5.8%, with the dividend comfortably covered by earnings.
Standard Chartered
Standard Chartered was once the bank that could do no wrong. Operating predominantly in Asia and emerging markets, StanChart comfortably weathered the financial crisis of 2008/9. By late 2010, the company’s shares were back to their pre-crisis level of close to £20. Today, they’re trading at about £10.
In some of its operations, StanChart has faced macro-headwinds, but it has also had company-specific issues. A rise in bad debts is one of a number of concerns that may yet result in a capital fund raising and/or a dividend cut.
Nevertheless, StanChart remains well-positioned to benefit from the long-term growth of developing economies. And, with the share price thoroughly depressed, a forecast P/E of just 11.4 and a yield of 4.7% (based on analyst forecasts of a reduced dividend), the stock could deliver for contrarian investors buying for the long haul.
Morrisons
Morrisons’ shares were well above £3 at the end of 2011. But changing shopping habits, and the assault on traditional supermarkets by no-frills discounters — notably Aldi and Lidl — have taken their toll. Morrisons shares are currently trading below £1.75.
Morrisons is a particularly unloved stock in a troubled sector. I think those contrarian investors who are buying in the sector are doing so on the basis that bigger is better, and are plumping for Tesco or Sainsbury’s over “weakling” industry no. 4 Morrisons.
However, Morrisons has a number of strengths that are perhaps overlooked. For example, historically, Tesco’s margins benefitted from its sheer size, but Morrisons’ margins weren’t far behind, thanks to its unique level of vertical integration. Sainsbury’s was the weakling on margins. Currently, Morrisons has the strongest balance sheet, and holds far more freehold property than its rivals. Tesco is the weakling when it comes to the balance sheet.
Morrisons’ earnings decline is forecast to bottom out this year. And with 20% growth forecast next year on a P/E of 13 — giving a very attractive P/E to growth ratio of 0.65 — the potential reward for contrarian investors could be considerable.
