Why contrarianism is a profitable strategy

It is natural for humans to come up with simple narratives to explain the world but in investing it is not always a good strategy.

Financial journalists often highlight neat causal relationships to explain price movements. Just last week The Squeeze made the case that the rise of populism and corresponding increase in fiscal deficits would push up bond yields.

We are still confident in this forecast, but in an increasingly connected world, feedback loops can be both positive and negative making outcomes particularly hard to predict. For example, populism could increase deficits and push up yields. Yet, at the same time, political instability in the US might spill over into the rest of the world causing a rush to safe assets. In this situation, economist Tyler Cowen makes the point that “if you wish to hold low-risk debt securities, US Treasuries, whatever their flaws, are the largest and most liquid market in the world”.

This isn’t just a weakness of individuals. Even markets, with all their combined 'wisdom', can be guilty of believing oversimplified stories. When Microsoft-backed ChatGPT was released at the end of 2022, it was immediately obvious that it was a revolutionary technology. The consensus then was it would be widely used, and this was proven correct, with ChatGPT racking up over 100mn users within the month.

However, without much understanding of the technology, the dominant narrative quickly became that it would undermine Google’s search business. At the time it seemed obvious; ChatGPT was being used for question and answer, and Google was the tool most of the world used to answer questions. This even empowered Microsoft’s chief executive Satya Nadella to go on the offensive. In February 2023, in a bullish interview with the Financial Times, he threatened that Microsoft would be using AI to take on Google’s search monopoly, saying: “There is such margin in search, which for us is incremental. For Google it’s not, they have to defend it all."  In the weeks after this interview, Alphabet (Google’s parent company) saw its share price drop to a three-year low of $89.

However, just over 18 months on, Google search has not been undermined. In Alphabet’s recent quarterly results, Google’s search revenue increased 12 per cent to $49.4bn. This was helped by its AI overviews that appear at the top of the search pages, and have been rolled out in more than 100 countries.

In fact, AI is entrenching Google users further because as they become more comfortable using the AI search tools they ask a wider range of questions and this produces better clickthrough rates on advertising. “This growth actually increases over time as people learn that Google can answer more of their questions,” said chief executive Sundar Pichai on the call.  

On top of this, Google’s cloud computing business which rents out Nvidia graphics processing units (GPUs) and its own AI chips, known as Tensor Processing Units (TPUs), grew revenue 35 per cent year-on-year. This was faster than Microsoft Azure’s 33 per cent and Amazon Web Service’s 19 per cent.

Narratives can be hard to dislodge though. That’s why, even despite this strong set of results, Alphabet continues to trade at a small discount to the S&P 500 and a significant discount to Microsoft. Even last month, Google DeepMind employees Demis Hassabis and John Jumper won Nobel Prizes for using AI to predict complex protein structures. Yet, Alphabet trades at half the valuation of fast-casual Mexican food chain Chipotle.

Winning a Nobel Prize doesn’t guarantee Google is undervalued. There can always be an unforeseen danger. But one thing is certain: in an increasingly complex world, simple answers are less likely to be right. So, if the market swings dramatically on a single narrative, think strongly about taking the other side of that bet.