Contrarian Investing

Contrarian is an investment style that goes against prevailing market trends by buying poorly performing assets and then selling when they perform well. A contrarian investor believes the people who say the market is going up do so only when they are fully invested and have no further purchasing power. At this point, the market is at a peak; when people predict a downturn, they have already sold out, at which point the market can only go up.

Contrarian investing also emphasizes out-of-favor securities with low P/E ratios. For more on indicators that contrarians monitor, check out the article “Why is the disparity index indicator important to contrarian investors?”

Contrarian investing is a type of investment strategy distinguished by buying and selling against the grain of investor sentiment during a specific time. A contrarian investor enters the market when others are feeling negative about it and the value is lower than its intrinsic value. When there is an overarching pessimistic sentiment on a stock, it has the possibility of lowering the price so low, the downfalls and risks of the company’s stock are overblown. Figuring out which distressed stocks to buy and selling them once the company recovers, thus boosting the stock value, is the major play for contrarian investors. This can lead to securities returning gains much higher than usual. However, being too optimistic on hyped stocks can have the opposite effect.

Many contrarians have the view of the market as an eternal bear market. This does not necessarily mean they view the market as negative but keep a healthy skepticism as to how certain general investors feel about the market. Overly high valuations can lead to eventual drops when investors’ expectations do not work out. The principles behind contrarian investing can be applied to individual stocks, an industry as a whole or even entire markets.

Similarities to Value Investment

Contrarian investing is similar to value investing because both value and contrarian investors look for discrepancies in price between investments, seeing if an asset class is undervalued in the current market. Many famous value investors see there is a fine line between value investing and contrarian investing as they both look for undervalued securities to turn a profit dependent on reading the current market sentiment. One main difference is the importance of the P/E ratio in value investing as opposed to contrarian investors who take this into consideration but also try to read the qualitative importance of the market, which includes media commentary, analyst forecasts and trading volume.

Relationship With Behavioral Finance

Contrarians also touch upon a lot of basic principles included in behavioral finance. Some behavioral finance ideas are that of investors as a collective and their interaction with trends. For example if a stock has been performing badly, it is going to stay that way for some time, along with a secure strong stock also staying that way.

How contrarian investing works

If stock markets are rising, the temptation is to ride it out for as long as possible and hopefully enjoy some gains. However, if the market is falling, your gut reaction might well be to get out as quickly as possible, to shield yourself from potential losses. Equally, why would you buy shares in a company or sector that the rest of the market is steering clear of?

Contrarian investing is all about going against market trends and focusing on shares and sectors, which have found themselves, for one reason or another, to be out of favour. Contrarian investors typically take a very long-term view when it comes to picking and choosing stocks. But the core of their strategy is that they believe the shares they buy have been unfairly dismissed and that ultimately a catalyst will emerge that will force the wider market to re-rate them.

Why following the crowd isn’t always the best strategy

During times of extreme market volatility, the easiest option might appear to be to play it safe and move towards so-called ‘safe haven’ assets such as cash and bonds. But while such a tactic may protect your portfolio, it could mean potentially missing out on some valuable investment opportunities.

It has often been argued that the optimal point to buy is when no one else has any intention of doing so. Take the technology bubble at the turn of the century, when investors piled into often-overvalued tech stocks. But when the boom turned to bust, many who had been following the market momentum were left nursing some severe losses afterwards. In contrast, many of those who avoided the peer pressure and instead looked at areas everyone else was ignoring found that their performance rebounded robustly when the market’s fortunes turned. Indeed, many contrarians invested selectively in tech stocks, which they felt had been unfairly brought down after the sector crashed.

More recently, the financial crisis threw up a variety of opportunities for contrarians and those who’d been brave enough to invest at the nadir of the financial crisis in 2009, enjoyed significant returns in the subsequent years of recovery. However, it’s important to appreciate that this is an observation of past performance of investments, which isn’t a reliable indicator of their future performance. Contrarians may have to wait a considerable time for the upturn or it may not come at all. Bear in mind it took the FTSE 100 15 years, in price terms to surpass its previous all time-high, which it achieved in 1999.

How to spot a potential contrarian play

There are a wide variety of funds available to retail investors which are run by contrarian managers and for the majority, this is probably the best way to access such a strategy, as their money will be spread across a wide range of shares. However, for more intrepid investors happy to shoulder some risk and select their own stocks there are a number of factors to consider.

It’s vital that you do your research before you invest in any company but avoid putting too much stock in hearsay and ‘hot-tips’. Have a look at a company’s website and check out its latest results and how it views its prospects. But bear in mind, just because a stock has performed well in recent times, it doesn’t mean its fortunes will continue. Equally, if a company has been having a tough time and its shares are down, there could be good reason for this – not every stock is destined to rebound.

One way of assessing whether a firm is worth investing in is to check out its price – earnings (P/E) ratio, which you can find by dividing a stock’s value by the earnings per share over the past year. The theory is that the higher the P/E, the better the investment looks – but this is just a theory, as a low P/E may not necessarily mean that a share is a bad bet but rather, it’s actually undervalued by the wider market. One way to get a clearer idea of whether this is the case is to compare the P/E of a firm with that of other groups in the same sector, to see how it measures-up against its competitors.

Always remember that the value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

Why it’s vital to always invest for the long term

Contrarian investing is only likely to be appropriate for skilled and experienced investors with a strong appetite for risk. Just because a stock is already down on its luck, this doesn’t mean it won’t fall further or that the company in question can’t go into liquidation. The obvious appeal of this style of investing is that you’re buying companies whose share prices are in the doldrums. As such, if these stocks rebound the gains made can potentially be substantial. However, the downside is that this can take some time to happen, and the real danger is that it might not happen at all. Whatever your investment approach, it’s hugely important that you have a long-term focus and a suitably diversified portfolio. No matter what stance you take, you have to accept that all investments can fall in value and you may get back less than you invest.