INSIDE INVESTOR: Hedging against the herd

Successful investors think independently. They don’t just follow the pack.

Take Warren Buffett, the octogenarian chief of US investment house Berkshire Hathaway.

He’s stuck to a couple of fundamental investment principles his whole life and he’s built one of the world’s most successful companies in the process.

One of his key strategies is to buy good businesses that nobody wants or when everyone else is selling.

During the depths of the global financial crisis, when everyone feared the entire banking system would collapse, he poured billions into some of America’s biggest investment banks at prices that are a mere fraction of what they now fetch.

He figured opportunities like that don’t come around too often. Almost everyone else in the world, fearing that Wall Street’s great investment banks were in danger of tipping over, couldn’t wait to get out.

Like any strategy, it is prone to risk. And Warren Buffett doesn’t always get it right. But he wins far more often than he loses.

The same opportunities presented themselves in Australia. Even though our major banks were well capitalised, even though the Federal Government guaranteed their deposits and guaranteed their offshore funding, investors dumped them like there was no tomorrow.

Why? Because of the herd mentality. Americans were selling their banks. So were the Brits and the Europeans.  Anyone smart enough to have bought Australian bank shares back then would be laughing now.

Surprisingly, these kinds of opportunities present themselves on a fairly regular basis. Just as some companies and sectors attract attention and are in hot demand, others fall out of fashion.

The trick is to determine why they are unloved. There is usually one of two reasons. Either they are in what is known as a cyclical downturn or they are facing structural problems. Sometimes it can be a combination of the two, which is really bad.

The fortunes of cyclical stocks change in line with the economy. They shoot up in boom times and lag during recessions or downturns. Usually, everyone buys in the boom and then sells for a loss when things turn sour.

The smart thing to do is to be a counter-cyclical investor: to buy good, well run companies when they are out of favour, and sell them when you think it just couldn’t get any better. If they can make money in the bad times, they really outperform when the tide turns.

Companies facing structural issues, such as technological changes that threaten an industry, can be far more difficult and are best avoided.