Contrarian Investing

 In simple terms, contrarian investing is about doing the opposite of what most people are doing in the stock market. A contrarian investor strives to identify and then capitalize on market inefficiencies driven by emotional "herd mentality." It is an investment strategy of going against the crowd, against the mob. If everyone is buying a stock and its price is going up quickly, a contrarian might avoid it or even sell it. On the other hand, if a stock is being sold by everyone and the price is falling, a contrarian might consider buying it. The concept is based on the premise that markets frequently overreact to good news and bad news. When prices go up too fast, they might be overvalued. And when prices fall sharply, they might be undervalued. Contrarians attempt to take advantage of these situations. Contrarian investors believe that by staying calm and thinking differently, they can find opportunities where others see trouble. It's about being patient, doing your own research, and not getting carried away by emotions.

There are numerous traits associated with a contrarian investor. First and foremost, contrarian investors are independent thinkers. They have the confidence to form their own opinions based on their analysis of fundamental factors and market trends. They have the ability to tune out the noise of the financial media and ignore short-term fluctuations in market prices. Contrarian investors have the courage to go against the crowd and take positions that may be unpopular. They have an abundance of patience and discipline, as well as possessing a long-term perspective on investing. Contrarian investors have the resilience and emotional control to stay committed to their investment thesis, even in the face of adversity. They are lifelong learners who continuously seek to improve their investment skills and adapt to changing market conditions. Additionally, they are open-minded and willing to learn from both their successes and failures. Last, but not least, contrarian investors ultimately focus on value. They are not contrarian for the sake of being contrarian, but rather because they believe that the market is not always efficient in accurately pricing. Contrarian investors seek to identify undervalued opportunities that offer the potential for attractive returns over the long haul.

A major challenge for contrarian investors is accurately identifying undervalued opportunities. This can involve extensive research and a deep understanding of fundamental analysis. Furthermore, simply - you could be wrong. Just because everyone else is selling doesn't mean they're wrong. Sometimes, a stock falls because the company is genuinely in trouble. There are a few general guidelines to consider when determining whether or not a stock qualifies as a contrarian play. The first requirement would be the "down-by-half rule." A stock must be down at least 50% from its highest closing price during the past 12 months. Another prerequisite would be a price/earnings (P/E) ratio of less than 12. Normally, "beaten up" stocks that are undervalued are selling at low multiples. The contrarian investor is also looking for a company with a price/free cash flow (P/FCF) of less than 10. This metric is extremely important. It never ceases to amaze me how often free cash flow is ignored. Another buy signal would be significant stock purchases by insiders. When it comes to knowing when to sell a contrarian play, it is quite simple: Sell once the stock rises 50% from its purchase price, or after three years, whichever comes first.

Numerous studies support the premise that "down and out" stocks frequently rebound and turn the table on peers that were considered "winners" in a given year. Using 36-month performance spans, two prominent researchers, professors DeBondt and Thaler, created portfolios of "loser" stocks (those that had performed worse than the market), and "winner" stocks (those that had beaten the market). Their findings: You're better served buying losers than winners. An investor who put together a portfolio of loser stocks and held it for three years would beat an investor who assembled a portfolio of so-called winner stocks by 25%. The emphasis on a three-year holding period echoes the approach of Ben Graham, the universally acknowledged mentor of Warren Buffett. And, Mr. Buffett arguably just happens to be the second greatest investor of all time. He religiously subscribed to value and contrarian investing principles.

There are a couple of factors that can undermine the traditional contrarian strategy. The 800-pound gorilla in the room is "large, mindless robot investing." This is a term attributed to Mike Green that describes the enormous, automatic flow of capital via 401(K) account contributions into passive investment vehicles like index funds and exchange-traded funds (ETFs). Passive flows now account for more than half of the funds flowing into the stock market. Unlike active fund managers who make discretionary decisions based on stock valuations and other factors, passive funds have a non-discretionary mandate to simply track an index. When an active manager might sell an overvalued stock, a passive manager will buy more as its market share grows. This insensitivity is a recipe for disaster. Another distortion is created by the ever-increasing propensity of corporations to allocate significant portions of their profits to buying back large amounts of their own stock. No longer are buybacks restricted to just when a company's stock is deemed undervalued. Now this type of financial engineering is utilized even if the stock is fairly valued or overvalued. This is another example of insensitivity to price.

Although I don't consider myself a full-throttled contrarian investor, I do share some tendencies common to that approach. This is not surprising since by nature I question many common assumptions after discarding my rose-colored glasses several decades ago. In my mind, it is preferable to be skeptical instead of naive and gullible. I feel knowledge, understanding, and the truth supersedes conformity, even in cases where the contrarian position is unpopular with the majority. We are living in an era when so much of what we have been told to be true is in fact false. I would rather be wrong with my viewpoint and change accordingly, than to blindly accept something as the gospel.