Buy these 6 stocks to invest like a contrarian in this challenging market setup, says a fund manager who's beaten 99% of peers in the last 10 years

  • Stocks are diving after rallying from mid-June to mid-August, and more downside may be ahead.
  • James Davolos, a portfolio manager in the top 1% over the past 10 years, shared his market outlook.
  • Here’s how Davolos selects stocks — and six of his top picks right now.

The massive rally the stock market has enjoyed this summer is slipping away fast.

There’s been much debate among market pundits as to whether the S&P 500 will fall back to its mid-June low of 3,636 or suddenly rebound and retest record highs — or perhaps it will do both.

A recent string of losing sessions for the widely followed US stock index suggests that investors are bracing for more pain ahead. Like many investors, James Davolos, a top-performing portfolio manager who co-manages the Kinetics Small Cap Opportunities Fund (KSCOX), doesn’t foresee a dramatic rally taking place anytime soon.

“I don’t know if we’re going to see lower lows, but it’s really hard to envision a scenario where we make all-time highs,” Davolos told Insider in a late August interview. “Gun to my head, I would say we’re much more likely to retest lows than highs.”

Admittedly, Davolos knows that he can’t predict exactly the future, especially given the “tremendous amount of uncertainty” that he said is facing the economy as the Federal Reserve warns of pain ahead as it struggles to get rampant inflation under control.

But investors would be forgiven for thinking that Davolos has a crystal ball. His fund has outperformed 99% of peers, both this year and in the past 10 years, according to Morningstar, and has logged top-3% finishes in 2012, 2013, 2017, 2018, and 2021.

Davolos told Insider about his market outlook, his fund’s strategy, and his favorite stock picks.

Inflation may persist, even as the economy slows

Economic strength is fading fast as leading indicators start to roll over, Davolos said. For instance, the latest reading of the Empire State Manufacturing Survey, which details business conditions in New York state, was the weakest it’s been since mid-2009, he noted.

It’s clear to Davolos that the Fed’s aggressive interest rate hikes aimed at combating inflation are having an effect, but it may not be the one that the US central bank is hoping for. There’s a chance that higher borrowing costs result in a spike in unemployment without bringing down what Davolos called “extremely elevated” inflation. That would be investors’ worst nightmare.

“I think the Fed’s going to have a really tough time balancing employment goals with inflation goals,” Davolos said. “I think that, ultimately, the lesser evil is going to be an acceptably higher level of inflation.”

Davolos said he’s preparing for higher-for-longer inflation in the 3% to 6% range. That will put pressure on corporate profit margins and, by extension, earnings, the portfolio manager warned.

“Regardless of what happens to the economy in nominal or real terms — whether companies can continue to grow the top line — the one guarantee is that profit margins are going to be squeezed,” Davolos said. “Because everything from raw materials, to labor, to transportation — all of these costs are going up, and I think they’re going to be really sticky.”

Markets aren’t pricing in a decline in earnings, Davolos said, echoing a concern recently voiced by Mike Wilson, the chief investment officer at Morgan Stanley. The Fed won’t pivot away from their hawkish policies, Davolos said, which will catch investors offside as the economy weakens.

“I don’t think the market has even remotely become close to — at least in terms of forward earnings forecasts — I think we’re only down like 2% or 3% — maybe 4% — from peak forward earnings estimates,” Davolos said. “I think the average recession is about 22%. If you factor in margin compression with that, it’s a pretty tough setup for the broader market.”

How to invest: 3 tips to remember

There are three pillars to the success of Davolos’ fund, the portfolio manager said: keeping a long time horizon, avoiding stocks that are heavy in indexes, and focusing on valuations.

Focusing on the long term is a simple tip that’s easy to forget in a 24/7 news cycle. While investors should follow what’s going on in the economy and markets, overreacting to day-to-day changes can backfire.

“So many people are concerned with what the quarter’s going to look like or the year is going to look like,” Davolos said. “But we think that if you push your view out and try to assess value over a period of several years, you have a much higher degree of success.”

The next two pillars are related. Davolos tries to avoid stocks that are large components in indexes because they are then included in popular funds and get blindly bought by investors, which results in these stocks becoming overinflated and eventually ripe for a decline.

“There’s been a tremendous amount of distortion in financial markets by virtue of valuation-agnostic buying from indices,” Davolos said.

That so-called distortion is an issue because high valuations can tank stocks, as investors have learned this year. Buying shares of companies that have solid growth, capital expenditure, cash flow, and profit margins is critical, Davolos said, and it’s rarely done by following the crowd.

“In order to be good at value investing and seek out value opportunities, you do need to have a reasonable degree of contrarian thinking,” Davolos said.

Top stock picks

After finding the right stocks to buy, it makes little sense to water a portfolio down by including too many names, in Davolos’ view. That’s why he said his fund tends to be “fairly concentrated and fairly top-heavy” in 25 to 45 names, with outsized weightings in 10 of those.

“Basically, we do a lot of rigorous research, and we want to own the best companies at size rather than a broad representation of the industry,” Davolos said.

Similarly, after finding the right names, Davolos usually keeps them in the Kinetics Small Cap Opportunities Fund for five to seven years, he said. Davolos said the fund scales in or out of stocks instead of buying or selling them all at once, unless there’s an “extraordinary situation.”

Below are six stocks that fit Davolos’ criteria and are among his favorite stocks. Along with each is its ticker, market capitalization, price-to-earnings (P/E) ratio, and commentary from Davolos.