Contrarian investing means doing the opposite of a popular investment trend. Contrarians seek to profit by taking a position that runs counter to conventional wisdom. When the herd overreacts to short-term information, it causes exaggerated price swings and investors can profit from the reversion to the mean.
Whether it’s to the upside or downside, contrarians look for crowd behaviour among investors that leads to the mispricing of securities, and since markets move in cycles, behavioural patterns become somewhat predictable.
For example, the bull market typically begins with a gradual rise in prices of a previously out-of-favour or new asset class. A few early investors have started to recognize its inherent value, while the rest continue to remain wary.
After a lengthy period of upward momentum, the trend gains traction, people start taking notice and media coverage intensifies. The majority of institutional investors take part and the large infusion of capital causes the price to rise, finally enticing the public to get in on the action. As the price keeps rising, a sense of euphoria begins to set in.
Be prepared to be unpopular
By going against the grain, contrarians can access opportunities that others may not see. For instance, Warren Buffett was chastised for not participating in the irrational exuberance of the tech stock rise that overtook markets in 1999 and early 2000.
This made him unpopular amongst some of his own shareholders and the media, but he was redeemed after the crash.
The contrarian approach requires applying alternative ideas and concepts to enhance investment returns. In other words, to do better than average, do something different—whether it’s shorting stocks that have been driven to unsustainable levels, or purchasing unpopular and undervalued stocks.
Here are three ways to go against the herd.
01 Be an independent thinker
Do your own research. We live in a time where the frequency of information we receive is high, but to think clearly and independently, tune out the majority of short-term market news.
Instead of basing your decisions on the minute-by-minute information reported from a breaking-news location, make them after examining the hard facts in a company’s annual reports.
When you do your research, realize that our minds are programmed to look for evidence supporting our original hypotheses. To counteract this behavioural bias, challenge yourself to find contradicting evidence to disprove your thesis.
Ask, “What conditions or factors need to materialize for your investment strategy to lose significant value over the long-term?”
Also, stick with what you know. Investing in companies where you have a good working knowledge of the business will reduce doubt in the decision-making process.
02 Let valuation be your guide
Extreme bullish or bearish market sentiment can serve as a good contrarian indicator because it typically reflects where the market has been, not where it is going. But for individual stocks, you must recognize the difference between stocks that possess real value and value traps.
A stock offering value to investors is one whose price has fallen below or risen far above a company’s inherent value.
It can be purchased and held in hopes of the price rising to meet its true value, or shorted in hopes the price will tumble. A value trap, on the other hand, is a security whose price is cheap for very good reason: poor products, bad strategic direction, out-of-control costs, or shrinking market share.
Earnings season provides us with a classic example of a company’s stock price disconnecting from its inherent worth. After a company reports a disappointing quarter, investors become disenchanted with the stock. As they sell, others follow suit and the resulting pressure drives the price down.
While the public is running for the hills, contrarians who have done sufficient research may see bargains. They know some of the best deals can come from rummaging through the market’s discount bins.
To avoid getting caught in a value trap, search for companies with solid management teams, innovative products and efficient processes that produce healthy profits for the foreseeable future. Companies that fit this bill are better suited to weather periods of unpopularity.
03 Keep your emotions in check
Investors have a tendency to be overconfident and often make decisions based on emotions rather than fact.
It can be a challenge not to get swept up in the pessimism that causes markets to dip significantly, or the optimism that leads to high prices and bubbles — but it’s imperative we do.
Realizing this natural weakness will help keep emotions in check during the decision-making process. Also, education and sound intellectual frameworks will minimize emotional interference.
A contrarian investing approach may not be a popular topic to discuss around the water cooler, but it does have the potential to generate handsome profits. You don’t make money by following the crowd — you make money by leading it.
Time to buy in Europe
There are great deals for stock pickers in the Eurozone. That’s because downside risk is falling in the region, says Nick Langley, investment director and senior portfolio manager of RARE Infrastructure in Sydney, Australia. His firm manages the Renaissance Global Infrastructure Fund.
As tail risk has fallen, equity markets have bounced, Langley adds. He expects political leaders, the ECB and other supranational Eurozone institutions to “do just enough to keep the Eurozone together.” Even if Greece exits, its ousting shouldn’t affect the region as a whole.
Instead, the zone’s primary task is to iron out imbalances between the different economies. This, Langley says, will take years. So he expects GDP growth to be below average for at least the next decade.
“When we plug that into our financial models, and model all of these companies on a bottom-up basis, the infrastructure-style companies look less attractive, and utilities look a little bit more attractive,” he says.
When you factor in sovereign risk, however, some companies look much better than others.
“Governments are trying to find ways to reduce spending and raise taxes, and a number of those programs are impacting the utility companies and other corporates,” Langley explains. “We need to be careful of which companies we choose and in which areas.”
France has hiked corporate taxes and reduced the deductibility of interest charges in tax calculation, for example, which has increased the effective tax rate.
“There are a number of quite thorny issues in Europe,” he adds. Overall, current conditions in the Eurozone are ripe for the bottom-up stock picker.
Langley concludes, “It’s an interesting market in that most people are focused on the big-picture macroeconomic issues. However, if you take the stance that Europe will remain as essentially one bloc, it actually is very much a stock picker’s market.
“Companies, industries and sectors are going to perform quite differently under those long-term economic conditions.”
Susy abbondi is an equities analyst at Duncan Ross Associates.