Should contrarian investors avoid commodities?

There is something of the teenager in most fund managers. Take their clothes. They mostly wear the same kind of suits, but some - to show their wacky individuality - wear red socks or braces.

Wearing red, you see, is okay because so many other City folk are showing their individuality in precisely the same way.

Then think of their investment styles. When did you last meet a fund manager who told you that when it comes to investing he finds it quicker and easier to just buy what everyone else is buying? Probably never.

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Instead, most fund managers will tell you they are contrarians -they are seeking value where nobody else has thought to look, buying in sectors and markets their more conventional competitors don't dare consider.

This is nonsense. Here too, fund managers famously follow the crowd: they know they can't afford to underperform the other managers -their reputations and bonuses depend on it - so they generally can't make themselves take the risks that might help them genuinely outperform either.

When they move away from the crowd they feel vulnerable. The result? Most UK funds contain much the same stocks as each other, and perform in much the same way. This is a great shame, because contrarian investing, however uncomfortable it may be for managers, really does appear to work.

Why contrarian investing works

A new paper from American academics shows that between 1982 and 2004 the shares that US institutional buyers were buying the least of outperformed those that they were buying the most of - by a significant margin.

This makes sense: if everyone agrees that an investment is a fine one they will all have already bought it and its merits will therefore all be reflected in its price, suggesting the return from it is unlikely to be unusually good. It also makes sense that if nobody is interested in a particular investment it could well have overlooked merits that are not reflected in its price, and hence be cheap.

The less accepted an investment is, and the more uncomfortable it is to make, the more likely it is to make you money.

So what should those prepared to put up with the pain of being contrary be doing now? A few years ago this was an easy one: the answer would have been to buy commodities.But that's not the case any more. The idea of the commodities super cycle (that a 20-year bull run has only just begun) has spread throughout the investment world and along the way become less of a contrarian and more of a consensus view. Today prices are up hundreds of per cent from their lows, analysts have spent the past few months busily upgrading their forecasts for mining companies (better late than never) and everybody is overweight in miners and oil groups.

Is a commodities correction on the way?

Those in any doubt need only look at one week's worth of headlines in the investment press: last week they all ran stories on investing in oil. I am still in no doubt that the underlying trend here is a good one (Asia, India and China are going to keep growing, and keep demanding vast amounts of commodities) but in the shorter term the market seems to have projected it too far into the future.

Prices have moved too fast for comfort as hordes of speculative investors have entered the market. To me, that suggests a nasty correction may be on the way. If I were a short-term investor I would be tempted to see the huge fall in the silver price (14% in one day) last week as something of a warning.

My view on this has been bolstered by the fact that LCH Clearnet, the clearing house for the London Metals Exchange, appears to be a tad worried about the market: it has started to insure itself against falling prices by raising the cost of trading in the metals market -the margin (the deposit put down to cover any losses on a deal) required to trade a set amount of copper or zinc has doubled.

The bull market in commodities isn't over by any means, but it isn't going to keep moving in a straight line: gold will hit $1,000 an ounce and oil will hit $100 a barrel - maybe even this year - but they may well see $500 and $50 again first.

They are now $680 and $71.

First published in The Sunday Times (07/05/2006)