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Sun 21 Jan 2007 12:00 AM

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Contrarians and Cassandras

The earnings season is fast approaching. Stephen Corley examines whether it is best to go it alone and to follow the crowd.

Although contrarian thinking is an important ingredient to investment success, running against the crowd doesn’t always produce success.

As noted trader Humphrey Neill put it 40 years ago, the essence of a contrarian approach is to realise that when everyone thinks alike, everyone is likely to be wrong.

The great myth, however is to assume that simply betting against everyone else will produce great results.

Not so. As the crowd isn’t always wrong, the art of successful contrary thinking is in its application.

Given the current state of global markets, a postgraduate degree in applied contrarian thought may be the best way forward in the short-term. Not only does the rear view mirror look clear but the long absence of any hazards also seems to be leading everyone to assume the view ahead is clear of any obstruction.

This smugness and optimism is so uniform that on the subject of global asset prices whilst I am no Cassandra, I fear the worst.

If this happens (although it may spark further panic throughout the GCC) in an area already depressed from the twin bogeys of falling oil prices and utterly traumatised stock markets, frankly the herd is screaming run when the signs here are quite encouraging.

Technically speaking, I admit the whole regional stock edifice looks shaky. Saudi Arabia looks hideous on a chart and we could see one last ditch sell off, which would almost certainly cross contaminate the Dubai Financial Market (DFM) before any recovery can take place.

Of course, after a bloodbath, markets often need a long time to consolidate at lower levels prior to an upswing.

But after months of frankly baseless optimism about the future of the local bourse, I find much to be encouraged in the reversal of attitudes now to the DFM and with the doomsayers out in force. True, the Kingdom of Saudi Arabia is contagious but Dubai LLC is steaming ahead and this should be reflected in the upcoming year-end figures.

Not necessarily for the banks, who should be hit by a fall in management fees and income from the sale of securities and the lacklustre IPO market, but negative profit growth even here is not necessarily a cause for alarm and despondency.

It is impossible for any sector to continue the kind of profit growth experienced through 2005 and it’s unfair to expect it or to penalise companies if they fail to achieve it.

And there lies the rub, over expectation and misguided perception rule the roost.

Take Emaar Properties. It’s difficult to avoid it as an example because of its size and dominant position, frequently hogging 30% of the total trades in the DFM during these less liquid times. Forecast profits of US$1.7bn put it on an implied P/E ratio of around 11, which is not expensive.

On an international scale, however, it has extremely high profitability, with a 57% gross profit margin.

Many local companies have similar margins of less than 10% hence Emaar's profits will increase faster than others if the volume of its business grows as the economy does, which of course it is still doing.

But once again it’s all about perception.

The perception is that Emaar has to do better than anyone and if its profits do not rise at the staggering level of previous years then the stock will fall. Its not Emaar’s fault, it is investor greed and a lack of understanding as to what the vital factors are that group together to help determine a company’s share price.

The DFM is a retail driven market and these are the most speculative investors but it is high time they began to look at realistic growth patterns and stop the lunacy of recent years.

Stupidity got us into this mess, so why can’t it get us out? It may do eventually but if it is remotely possible to adjust investor expectations and then bring depth to the market through more IPOs that are logically priced and in diversified sectors, then it should be reasonably straightforward to pick out growth stocks and remain invested in them.

Of course the DFM has now announced that it will start trading in the first or second week of February trading on the DFM itself, following the oversubscribed initial public offering of part of the exchange in November last year. With that in mind the earnings season kicks off next week and this is going to throw up some interesting stories — not by any means bad in many cases but as usual we'll have to see.

On that basis, I hope the Cassandras rally forth and let the contrarians among us dip our feet in the water.

It feels like the right time but only if the lessons of the past have been learned.

Stephen Corley is a business consultant with experience in fund and asset management.

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