Contrarian Investing: Redefining the investing basics [Finance Friday]

I paraphrase Lord Rothschild: ‘The time to buy is when there’s blood on the streets.’

The strongly-held belief that the worse things seem in the market, the better the opportunities are for profit generation, forms the foundation for contrarian investing. A contrarian is early in investing in companies that have potential, even as the herd may be more focused on the risk associated with the company. Great investors like Warren buffet, David Dreman, Mark Ripple & John Templeton names are synonyms with contrarian value investing strategies. Their investment styles respectively are testimony to the success of contra strategy.

Generally in stock markets where stock prices move up and down on a daily basis without any change in the fundamentals of the companies illustrates herd/crowd behaviour. If you notice investments in the stock market, you will observe that they move in herds most of the time and this influences stock prices.

For example, if a company announces mega investment plan in an emerging area, the stock price of the company indicates rally immediately without looking into the prospects/gestation period, impact on financial statements, cash inflow or net earnings from the investment to be made in this project. That is often mentioned as the behavioural finance/economics which looks into the cognitive psychology to account for the irrational and illogical behaviours that modern finance had failed to explain. Many finance practitioners have explored this field further following fathers of behavioural finance namely Daniel Kahneman and Amos Tversky.

Over the years it’s been observed that contrarian strategies have fared well even during recession. These strategies are based on factors other than the usual parameters of choosing a sector/industry/stock. To give you an insight, here are few of the contrarian principles tried & tested:

Firstly, invest in the fundamentally sound companies that are currently overlooked among investors. Secondly, identify opportunities.

All stocks have a life cycle – attractive stocks perform – Herd follows:

• Stocks acquire momentum
• Momentum results in overvaluation
• Stock loses its sheen & herd loses interest
• Contrarian opportunity arises.

Positive changes follow & contra stocks become attractive. The cycle repeats itself; the key is to spot the catch at the right time to buy during periods when the market is characterized by maximum pessimism & foresee the downfall to exit at the right time.

As the marvel ‘Warren Buffet’ quotes it..

“Do not follow the crowd. Ignore the market, the crowd, and its fashions.”

So you cannot forge ahead with the conventional investment guidelines. If you want to have a better performance than the crowd, you must do things differently from the crowd. For a contrarian, decoding the Matrix i.e. knowledge of market dynamics & sound financial analysis is critical. Looking at the unstable & unpredictable condition of stock markets today contrarian strategy is surely going to work.

The contra strategy would differ from person to person, as it’s not learned but mastered over the years, at first instance you might not garner the profits but as it goes no gain without pain. For instance in 1969, Dreman, a renowned contrarian investor, was following the crowd as the shares of companies with negligible earnings skyrocketed and lost 75% of his net worth. The aftermath of that painful lesson was that he became a legendary contrarian investor.

The investment style would be as distinguished & individualistic as the person; Going against the tide has to be recognized as contemplative & competitive at the same time.

Are you game for it?