Contrarian Investing 101

How to be Contrarian without Getting Killed

Contrarian Investing 101
March 13, 2015

A contrarian is defined as “a person who takes an opposing view, especially one who rejects the majority opinion.” In the world of investing, contrarians seek to invest in ways that are contrary to what everyone else is doing — or in other words, to “go against the flow.”

Contrarian investing can be a high-risk, high-reward strategy. Contrarian investors essentially believe that they know something about an individual stock, an industry sector or the market as a whole that nobody else does. If they are right, they can reap huge rewards. But if they are wrong, the losses can be just as large.

For example, bad news about a company, like a disappointing earnings report or lower-than-expected sales of a new product, can lead to pessimism among most investors and a sharp selloff. A contrarian investor might believe that the company’s fundamentals are sound and the sell-off is temporary. If so, he or she would buy the stock after the price has fallen and then hope to profit when it starts to rise again in the future.

On the flip side, a contrarian investor might believe a stock that has risen sharply in a short period of time does not have strong enough fundamentals to justify the rise, and will fall just as quickly at some point in the near future. He or she would avoid buying this stock, or might consider short-selling it to realize a profit when it does fall.

Well-known Contrarian Investors

Warren Buffett is probably the best-known contrarian investor. He is constantly looking to buy stocks of companies that are fundamentally sound, but which negative market sentiments have driven down to a price that is well below what he believes it is actually worth. David Dreman, Mark Ripple, Marc Faber and Jim Rogers are a few other well-known and successful contrarian investors.

Contrarian investing is often similar to value investing, in which investors try to find securities that are undervalued by the market and priced too low in comparison to their intrinsic value. In fact, some experts, like long-time Vanguard mutual fund manager John Neff, question whether there is even a distinction between the two. One difference is that value investors look primarily at metrics like price/earnings (P/E) ratio or book value when identifying value stocks, while contrarian investors look at measures of investor sentiment in addition to these metrics.

Investor sentiment is measured by volatility indexes, also referred to as “fear indexes,” One popular fear index is the Chicago Board Options Exchange (CBOE) Volatility Index, more commonly referred to as the VIX. This index provides a numeric measurement of the level of pessimism or optimism among investors at large. The lower the VIX, the more confident and optimistic investors are — the higher the VIX, the more pessimistic investors are. Over time, peaks in the VIX have generally corresponded with good opportunities to buy undervalued stocks.

One common and relatively simple contrarian investing strategy is known as the “Dogs of the Dow” strategy. Here, you would buy stocks listed on the Dow Jones Industrial Average with high relative dividend yields due to falling share prices, not raised dividends, and then sell them when they inevitably rise. By following this strategy, you would systematically buy the Dow’s most out-of-favor stocks when their prices are low and then profit by selling them when they are in favor again.

Going Against the Grain

Contrarian investing can be profitable when it works, but it can also be risky. After all, it essentially involves betting against what almost everybody else is thinking or doing at a particular point in time. “Running against the herd” and “marching to the beat of your own drum” might sound exciting and adventurous, but in reality, the herd is usually right. So successful contrarian investing requires the ability to infer when most others are wrong — and your hunch is right. Here are five pointers that may help you become a successful contrarian investor:

  1. If an important stock development is in the news, it is probably too late for you to profit from it. Successful contrarian investing usually requires obtaining information about companies and stocks that other investors have not yet uncovered. If key information or developments are being broadcast on CNBC or splashed across the front page of Investor’s Business Daily, then you have lost the early jump and the competitive investment advantage.

  2. It is better to do your own research and due diligence than rely on “hot” stock tips or advice, even from so-called experts and pros. Given the importance of getting information about companies and stocks early, you must be willing to roll up your sleeves and perform your own stock research and due diligence. This is the only way to “scoop” the rest of the investing herd and profit by going against the grain.

  3. Learn to view information through a different lens. The successful contrarian investor is able to look at the same information as other investors, but see something different from what everyone else sees. This takes discipline and practice, but with time and experience, you can learn to spot the nuggets that others do not see, which can lead to profitable investments.

  4. Don’t just focus on sexy, well-known stocks — also look at stocks that fly under the radar. It is easy to follow and research the stocks of companies everybody knows about that are doing cool, exciting things — companies like Apple (NASDAQ: AAPL), Amazon (NASDAQ: AMZN), Facebook (NASDAQ: FB) and Google (NASDAQ: GOOG and GOOGL). However, stocks that are good contrarian bets are usually less well-known companies in boring industries like chemicals, manufacturing or transportation, for example.

  5. Have a thick skin, persistence and some serious “stick-to-it-iveness.” Precisely because it involves going against conventional wisdom, contrarian investing requires that you have strong convictions about your investment research and conclusions, as well as a willingness to stick with your decisions in the face of short-term adversity. It is probably not a good idea to watch too much CNBC if you are a contrarian investor, since this might cause you to start questioning the decisions you have made.

Contrarian Investing May Not be Right for You

Contrarian investing is not for everyone. Not only does it tend to be riskier than most other investing strategies, but it also requires a lot of investment research and the ability to see information differently and make decisions that others might not only disagree with, but also even ridicule. However, the rewards for successful contrarian investing can be tremendous. Just ask Warren Buffett.

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