Mary, Mary, quite contrary, where will resources go?

Contrarian investing is often understood as buying stocks when everyone is selling. But there is more to it than that.

Rather than defining a contrarian investment it is more prudent to ask what constitutes a contrarian investor. If we know what a contrarian investor is like we will be better able to identify the type of opportunities she would consider investing in.

How would we define Mary? Warren Buffet would say she is a thinker. She has to identify opportunities that the market has mispriced or that are divergent from market momentum. She is fearless. It’s not easy to be a contrarian investor, so she must be stubborn too. So far, we have identified attributes most investors would give to themselves.

Mary does something different though. She is unpopular. She not only has a long-term view, but she also looks for opportunities by looking at correlations, trading volumes, price patterns, earnings forecasts, and P/Es. Mary is a little bit quant, a little bit intuitive and she has a lot of imagination.

Have a look at the trading patterns of two indices that one would expect to move in the same direction: the Market Vectors Australia Energy & Mining Index (ASX: MVR) and the Market Vectors Australia Junior Energy & Mining Index (ASX: MVE). One is a broad based resources index and the other focuses on junior resources.

One would expect the ‘junior’ index to be more volatile but trade around the larger cap index. Indeed, this is the case up until December 2012. One would expect these two indices to be impacted the same way by the same macro themes. However, for whatever reason, the market has given them a vastly different value in the past 18 months.

Look at the graph below. This is the excess of MVR’s larger cap index over MVE’s junior index. It has never been greater. In the past the two have always reverted back to zero.

Which market value is correct? Will MVE revert upwards? Will MVR fall?

MVR’s performance has been stubborn despite recent falls in iron ore and coal prices as macro news has been dominated by China deleveraging, Ukraine uncertainty, and global growth constraints. Stubbornness is one of Mary’s characteristics.

Junior resources and energy stocks for whatever reason are unpopular. Just like Mary. It seems investors are more cautious about the smaller and mid-cap opportunities despite the fact that the potential growth of those could be greater.

We think Mary, who is quite contrary, might consider MVE. To quote Buffet, “Be fearful when others are greedy and greedy when others are fearful.”