Contrarian investing is when an investor goes against the investing crowd - selling what other investors buy and buying what the others sell. Contrarian investors, like David Dreman, believe that investors tend to overvalue certain asset classes and underestimate others. Such overreaction backfires when the much-anticipated asset does not perform overly well, leading to its crash, leaving contrarian investors to buy it up.
In this article, we will look at contrarian investing and answer the following questions:
- What is a contrarian investing?
- Understanding contrarian strategy
- How effective is contrarian investing?
- Contrarian stocks and funds to consider
What is a contrarian investing?
Contrarian investing is a strategy where investors go against the mainstream investment behaviour to make a profit. If the crowd is focusing on tech stocks, contrarians will do the opposite and sell them and only buy them when the hype dies down with the price. Contrarian investors believe that others only overvalue their assets because they have put all their eggs into that basket. They have no other option or purchasing power; therefore, their investment has to increase. To the contrarian investor, once the asset hits its peak - downward is its only natural course, and once an asset has met its low point, upward is the only direction. Hence, they will only prefer to buy an asset class once the value decreases and wait until it peaks again. In fact, contrarian investing only focuses on buying distressed assets and sell them once it gets popular amongst other investors.
Contrarian investing and value investing have some similarities - they both tend to lean towards undervalued assets they believe have an intrinsic value. Value investors also believe that the market tends to overreact to everything, and therefore, they jump on the short-term profit bandwagon.
Is contrarian investing good?
A contrarian strategy can be beneficial, especially if the investor does not give in to the market's fear and excitement as propagated by the media outlets. Since they are aware that they cannot time the market, investors take control of their own investments through the contrarian approach.
Whether contrarian investing is good or bad for you depends on your position in the investment. The plan is to rotate the positions of your assets that have gained significantly in value. And reinvest those gains in sectors that have declined in value that you believe have worth.
Because you are placing a single bet, this is not an "all or nothing" situation. Instead, you are only testing the probabilities by shifting your capital from overpriced holdings to underpriced positions. Thus, a contrarian strategy can be profitable since the upside can be enormous. Many contrarian investments have the possibility of asymmetric returns—that is, a large potential upside with a limited and measurable negative.
However, contrarian investment strategy may not be suitable for you if you are not willing to wait patiently for a long time. You will be tempted to sell short because of a lack of an increase in market value or simply because more people are selling theirs. However, some assets may rise in valuation within a few months, and some assets can take years (uranium, for example). You should confirm your belief by keeping up with asset valuation updates before you make a move.
Pros and cons of contrarian investing
Contrarian investment strategies are by nature long-term and more predictable than other types of strategies. As a result, investors already have to think long-term and research their chosen, currently undervalued assets before making the investment. Overvalued stocks provide security to a contrarian investor because they will sell them to realise their profits. For cheap equities, the only way is upward. Therefore, an investor only needs to ignore the hype in the market to avoid volatility and wait until it reaches its potential. Apart from the general benefits, studies have found that a contrarian strategy may help you outperform the market. The reason for this could be the investor's behaviour of long-term planning, preparation, and patience that influences their investment.
Consistent market sentiment is a common challenge with contrarian strategy. The market may not react to investors buying distressed or undervalued stocks, and the prices may remain low for a considerable amount of time. Contrarian investors will be unable to make money as long as prices remain low. Simultaneously, if all investors were contrarian, everyone would buy undervalued stocks, which in turn would create a confusing loop that would be hard to break. Furthermore, popular stock prices may continue to rise, which the contrarians had not bought prior to the rising valuation. As a result, they miss out on the profits of rising prices because the prices are always rising. As a result, contrarians can only make money and survive if the market reacts in the way they expect it will. There are countless studies against contrarian investing due to the mentioned disadvantages, suggesting that the contrarian strategy may not work, especially for short-term investments. This is due to the fact that you are in the market too early to evaluate the valuation of your chosen assets.
Understanding contrarian strategy
Contrarianism can be interpreted in two ways: firstly, those who do not conform to the norms of their social group; and secondly, we know that crowd wisdom can be valuable in determining an asset's worth, but we also know that crowds can overreact. Research shows that investors first underreact to facts, but then end up overreacting to attractive-looking stocks. This is the essence of contrarianism. Proper contrarians profit from the market's overreaction by selling these highly valued equities when others are buying them.
Contrarian investing can be used interchangeably with value investing as they both look for stocks whose share price is less than their real value. The difference between the two lies in their execution. Contrarian assets may include more exotic financial instruments like credit default swaps to play an overall trend and place a greater emphasis on investor mood. They may decide to purchase an asset despite its lack of popularity. Value investors tend to invest in only one or two stocks and typically rely on indicators like book value and P/E ratio to identify assets that are trading at a discount based only on the statistics.
Some investors mix the two strategies to achieve a successful outcome in their portfolio. This is known as "contrarian value investing," where investors do not buy stocks based on the low price alone, but also because of the financial safety offered by the growing companies (for example, through their balance sheet). This gives investors the space to have a financial cushion should things get tough. Contrarian value investing works well when valuations of assets fall, allowing investors to pick up valuable stocks at a discounted price. On the other hand, this strategy does not tend to do well, when the investment is based on faith that the company will do well in the future, but has not yet.
What are the methods to implement contrarian strategy?
A contrarian strategy can be implemented in a variety of ways:
- Some seek historical patterns in stock price movement
- Others react to momentum and buy stocks that are rising
- Others follow benchmarks
Although all methodologies have benefits, a valuation-based approach lends itself particularly well to contrarianism. Managers can implement the contrarian strategy by attempting to determine a company's intrinsic worth and purchasing shares when their price is significantly below that value.
There is no one answer to the question of how intrinsic value is calculated. Different measurements are required by different companies in different industries. First and foremost, the search should not be limited to "affordable" businesses. The stock market is replete with companies that appear to be attractively priced but have only gotten cheaper. The contrast between "cheap" and "undervalued" is critical. To tell the difference between cheap and undervalued stocks, you must first grasp what makes a company undervalued. Businesses that are undervalued usually fall into one of two categories:
- Compounders are businesses with good operating qualities, high and sustainable returns on capital, and solid management but are not popular
- Unique circumstances: businesses that are confronted with obstacles and need to evolve yet sell products or services that are still relevant
In addition, rather than being used as a beginning point, the price/earnings ratio should be used as an end point. It is an appealingly basic statistic, but it is far from conclusive. It is unable to reveal any existing or potential indicators of quality that could indicate a real valuation opportunity. Instead, a variety of criteria must be considered. These could include cashflow, balance sheet, return on capital versus cost of capital, earning growth potential, management team, and potential for improvement.
What contrarian investing strategies you can use to your advantage?
Sometimes the market is right - especially when so many people agree with it. Of course, you may be right if you have knowledge that no other possesses, but even then, the odds are stacked against you because you put your money in a dying product, and if it fails, you lose your money. Therefore, there are some contrarian investment tactics you can use to, at least, minimise your losses:
- Leaving it to the professionals: shorting is the key strategy of contrarian investment, and it can be very rewarding or suffer huge losses. As an individual with no training or knowledge, it is better to seek a professional who has the training required to help you with your investment
- Pick durable companies: companies that have been hit hard and managed to come back have implemented measures to survive throughout the pandemic. Choose the companies to invest in which constantly strives to innovate and adapt to the current market climate
- Research: nothing beats good old-fashioned research before investing in anything. Now that everything is available online accessing studies on investment is easier than ever. Utilise those access and make them work in your favour
- Diversify: the golden rule of investment, and it applies here like anywhere else
How effective is contrarian investing?
Contrarian investing can be very effective in bringing better yields because it goes against the norm. Since the average investors tend to focus on short-term goals and buy high and sell low, their portfolios underperform in the market.
A contrarian investor does the opposite - buying low and selling high and investing in assets when others are selling them. They constantly try to identify the assets which will bounce back from their downfall and reach new heights. Unlike the average investor, a contrarian investor will understand the nuances of market profit and loss.
Does this mean you have to take high risks for higher rewards? Not at all; risks depend on your tolerance. While all investments carry some form of risk, not all contrarian investing has high risk. Some can hedge against the risk by shorting their investment. It all depends on the risk tolerance of each investor.
However, like everything, contrarian investment has its downsides too. Even contrarian investment carries a low probability of success for the following reasons:
- Shorting investments may be time-consuming because it takes a long time for the value of investments to increase than decrease and an increase in one equity leads to elevate all others. Therefore, making a profit on shorting is next to impossible
- Contrarian investment still requires timing the market, which is tough, even for the most experienced investor
- Just because you find an intrinsic value in the undervalued asset does not mean it will yield profit. Some drops remain for a long time and may even go down further, incurring losses for contrarian investors
- Contrarian investing requires investors to identify the stocks and assets which are likely to implode in the future. That means a set of knowledge and expertise is absolutely mandatory to pick the best out of so many. If a group of experts and professionals cannot do that without suffering losses, how can an individual, with limited training and knowledge, expect to capitalise on it?
Who are some famous contrarian investors?
There are many notable investors who have taken a contrarian approach to the market. Bill Ackman is a well-known contrarian investor who has invested in Wendy's Company, despite market sentiment and left the company with a large profit.
Warren Buffett is a well-known contrarian investor who believes that the optimum time to invest in a stock is when the market's shortsightedness has beaten down the price, and he has proved his contrarian talent on numerous occasions during his life. He has bought undervalued assets that will grow significantly in the future. He repeated the same tactic during the 2008 crisis when he bought off some of the financial companies facing bankruptcy.
Ryan Cohen is a well-known value investor and contrarian. Through his company "Chewy," he was able to outperform Amazon in online pet goods sales and delivery, despite popular criticism. Chewy was sold for $3.35 billion by Cohen.
The last name mentioned in this list is George Soros. Analysts sometimes refer to George Soros as a visionary contrarian investor, citing his famous shorting of the yen and pound, which gained him $2 billion in profit.
Examples of contrarian investing
The contrarian approach to investing is best illustrated by John Maynard Keynes, an early investor who went against the crowd when he was in charge of the endowment for King's College in the 1940s. Keynes may have been the first institutional investor to put a lot of money into common stocks and international stocks. Most university endowments at the time were mostly invested in land and fixed income assets. On average, Keynes's investments outperformed the U.K. market by more than 6%. He used a strategy that was similar to, but not the same as, value investing.
Another example of contrarian investing was when Michael Burry shorted the housing market with his fund. He paid huge premiums to investment banks, which almost broke his fund because investors wanted their money back. However, his investment was proven to be successful, and he was able to make significant profits when the housing market went down.
Other contrarian investing examples include the Dotcom bubble, where assets like real estate and value stocks were profited massively while tech stocks crashed.
Contrarian stocks and funds to consider
There are a plethora of low-cost stocks and mutual funds that you could consider purchasing as part of a contrarian strategy. In general, you should seek out fallen sectors (with the potential to grow back) with below-average valuations. Commodity producers, retailers, consumer discretionary firms, industrials, midstream firms, asset managers, and so on have all been battered for now, but are expected to rise again in the future. International stocks and emerging markets have also underperformed in the last decade but are expected to rise. The following are some concrete industries that you may want to look into:
- Developing industry: New markets are developed every time. Examples are mostly related to tech, but it is not limited to it. While some traditional markets will remain, new markets will emerge and will take over the economy
- Commodities: Commodities include grains, gold, oil, gas, and many more, and these are the assets that are necessary for the economy and will rarely see a decline in value
- Non-traditional investments: This is not an alternative investment. These investments trade on things that are unusual and very different from the investment market in general - it could be ETFs on cannabis, pot stocks, funds on beer or wine or even NFTs
- Transportation: Cruise lines and airlines were hit hard in 2020, but they are more likely to bounce back due to their importance in the economy
- Small mom&pop business: Many small businesses have also been hit by the pandemic, and many of them will not bounce back. But some might through implementing innovative measures to suit the market climate, and an investor can take reap the benefits from their slow regrowth
- Real estate: Real estate is one of those asset classes that rarely crashes. Even when it does, it comes back up stronger than before. Real estate, whether land or through REITs, can still achieve a solid return that suits a contrarian approach. Also, not everyone can afford to invest in real-estate
Apart from focusing on the industries, you may also want to focus on the kind of asset. For instance, you can sell your cash-secured put options to buy a stock when it declines, or you can sell your covered calls to sell stocks when their prices increase.
Summary
To understand whether contrarian investing is right for you, look no further than its characteristics. As a strategy that looks for low-cost equities of companies that are expected to rise in value, it does strike some uncertainty as one cannot simply time the market. Nevertheless, contrarian investing can be beneficial if you are patient and rarely give into market hype and fear. But it also has its downsides. You can ensure that a contrarian strategy is a success by looking at equities holistically, through looking at company balance sheets, investment returns against investment costs, or using basic statistics, like price/earnings ratio. But nothing beats traditional investment strategies to ensure success, such as, proper diversification, due diligence, or seeking professional help. Contrarian investing can be very effective due to its long-term nature and the historical success achieved by famous investors, like Warren Buffet or Ryan Cohen. Some of the industries to consider for contrarian investing include emerging markets, commodities, and real estate, etc.
Contrarian investing can be beneficial if done right. However, as seen from history, only a few can reap the benefits because it requires expert support from trained professions. Warren Buffet had a group of professionals who helped him profit through a contrarian approach, and the individual will not have access to such tools. Therefore, it is essential to understand your goals, risk tolerance, and the current market before investing through the contrarian approach.