Finding Opportunity in Correlated Markets

When used in a financial context, the technical definition of 'correlation' is "a statistical measure of how two securities move in relation to one another". Recently, this typically obscure data point has moved into the lexicon of mainstream investors as it aptly describes the sort of stock market returns that we have experienced over the last few years. That is, returns have been highly "correlated" as the majority of stocks, irrespective of sector, industry, market cap, nation of origin or ostensible investment style (i.e., value or growth), have either done well, as in 2009 and 2010, or poorly, as they did in 2008 and 2011.

Why is correlation important? Correlated markets present definite challenges for disciplined contrarian investors like ourselves. There is simply not much incremental reward for the contrary stance when share prices are rising or falling more or less indiscriminately throughout the world's stock markets.

Our practice is to go against the grain by investing in companies or industries that most investors are neglecting while we ignore trendy or fast-growing segments of the market that others are championing. Our fundamental analysis seeks to identify discounts when intrinsic value becomes meaningfully detached from stock prices.

In general, we look for well-managed businesses with pristine financial profiles and histories of high returns on invested capital that are attractively priced on an absolute basis. To find these attributes in common often means that a company has disappointed a set of shareholders for any number of reasons such as poor management execution, challenging business conditions, increased competition or earnings misses.

While still in an environment that offers plenty of opportunity to locate these kinds of companies, often in industries that are falling out of favor and/or are nearing the bottom of a business cycle, our efforts are not being as distinctly rewarded.

Markets where correlation is more historically normal often see us enjoying the fruits of earlier contrarian investments that fit the profile we described. This combination of reaping the benefits of previous efforts while repositioning for the future has historically led to long-term performance differentiation versus both small-cap indexes and peers. Yet a correlated market can constrict both kinds of opportunity.

There are two other, related challenges: Highly correlated up markets tend to reward passively managed index funds and ETFs (Exchange Traded Funds) because of their inherently lower fee structure and fully invested status. Correlated downturns can also foster greater demand for these same vehicles as investors become frustrated with mounting losses. In addition, investors, losing sight of the long view, also tend to lose their appetite for actively managed products when short-term performance differentiation is diminished.

Unsurprisingly, then, a correlated market usually indicates a low tolerance for risk. While this can help over the long run—the rampant selling during the last seven months of 2011 created as large a set of purchase opportunities as we've seen in nearly three years—it also equates to ample levels of emotional and undifferentiated selling, which hinders more established positions from rising to price levels that our analysis indicates they are capable of attaining.

Throughout much of 2011, we found ourselves building existing positions and revisiting old favorites at least as frequently as investing in new companies. In all cases, our purchases comprised high-conviction ideas as we sought to ultimately tap the inevitable differentiation that occurs between corporate performance and correlated investor sentiment. While not necessarily rewarding in the short run, taking advantage of such mispricings remains the best way we know of building strong, long-term performance.