“When everybody thinks alike, everybody is likely to be wrong.”
– Humphrey B. Neill, The Art of Contrary Thinking (1954)
In life and the markets, many like to go with the crowd. People buy the same car that others buy, get the same phone others get, and in the stock market, they invest in the same equities others invest – never bothering to check whether it’s good for them.
You might ask – ‘what’s wrong with that?’
Well, before I tell you, first let’s take a look at what contrarian investing is.
What is contrarian investing?
Contrarian investing is an investment approach, where investors not only stop following the crowd, they move against it. That means selling when others are buying and buying or holding on when others are selling. Contrarians purposefully act against the majority opinion, by making investment decisions that oppose the prevailing market trends.
The core belief behind contrarian investing is that market direction is subject to herd mentality, resulting in markets being periodically under and over-priced. A contrarian investor believes that investors as a group tend to get over-optimistic with certain stocks, driving their price up to a point where the price can no longer be justified with the stock’s fundamentals.
A contrarian investor makes the most of these mispricing in the securities markets.
How does contrarian investing work?
Contrarian strategy involves identifying the prevailing market sentiments and going against them. Just to be clear, this does not mean going against the market, all the time. Rather, it’s about identifying and assessing the existing market conditions and when market sentiments seem to lean heavily in one direction, take the opposite side.
For instance, in the late 90s, investors were too excited about internet companies and bought every stock that had anything to do with the internet. This resulted in tech stocks going up more than 1000% in value. And all of it ended with the dot-com crash in the early 2000s. Those who moved with the crowd nearly lost all of their investments.
These are some of the characteristics of a contrarian investor.
Buy undervalued stocks
A major part of contrarian investing involves buying stocks that are trading below their intrinsic value. When a contrarian investor sees that the market has over-priced certain stocks, they look for the undervalued stocks. Bear in mind that some stocks are overpriced because investors, too optimistic, sold off certain other stocks to find the money to invest in these stocks – which are now overpriced. Once contrarians buy the undervalued stocks, they wait for the broader market sentiment to change and undervalued stocks will return to their fair value, generating profits for the contrarians.
Move against market sentiment
A contrarian investor also understands the importance of the behavioral biases of investors. For example, studies in behavioral science indicate that investors tend to overestimate the recent trend while predicting the future; the poor performing stock will continue to perform poorly, and a strongly performing stock will remain strong.
In fact, David Dreman, a contrarian investor and author of Contrarian Investment Strategies: The Next Generation, has often mentioned that we humans tend to be both overly optimistic and overly confident. Contrarians also understand that exaggerated optimism and pessimism can drive prices to extremes.
So the broad investor sentiment pushes the price of certain stocks well below their intrinsic value. That presents an opportunity for contrarian investors to grab those which are now trading below their intrinsic value.
Invest in a bear market
Another trait of contrarian investing is they are ready to invest in a bear market. Even though it is a lucrative idea for all investors – to buy stocks at a discount during a market downturn – very few investors actually pull it off. Most investors pass through a downturn or correction selling stocks but never buying any. Because let’s face it – it is extremely hard to put your money in the stock market when ‘doom and gloom’ surround you.
Contrarian investors, however, are ready to buy -especially- when the market is on a downturn. Bear or bull market, they’ll gladly enter into long positions in companies with strong financial fundamentals. This brings us to the next trait of a contrarian.
Have a long term outlook
Another reason a contrarian investor might gladly invest in a bear market is their long-term outlook. A contrarian investor understands that market volatility and extreme price swings are close to negligible when you invest for the long term. Because it has been proven that the market appreciates over time. This helps contrarians in riding out the market downturns. And once they do that successfully, substantial returns await them.
Also, since contrarian investors primarily invest in undervalued stocks, it might years for investor sentiment to change in favor of these stocks. That is another reason contrarians have a long-term outlook.
Look for strong financials
Contrarian investing also advocates for companies that have strong financial fundamentals. A contrarian investor understands that companies can have poor stock performance even with strong financials. They believe the broader market sentiment can have a blurring effect on investor’s outlook on non-favorite stocks, persuading investors to neglect their strong fundamentals.
So they focus on a stock’s intrinsic value – assessing the company’s financial and business fundamentals, which gives them a clearer picture of the company’s future. Also, by buying undervalued stocks they improve their chances of making a profit, simply by waiting for the stock price to return to its intrinsic value.
The investment strategy that focuses on the intrinsic value of a stock is known as value investing.
Contrarian and Value investing
Value investing is one of the most followed and widely respected strategies for stock picking. A value investor aims to buy stocks that are trading below their intrinsic value. And it is quite similar to contrarian investing. Both aim to buy undervalued stocks to make a profit when it returns to its fair book value, both have a long-term outlook, and perhaps more importantly, both follow the principles of going against the crowd.
Both contrarian and value investors understand that people tend to overreact to good and bad news and hence the short-term price movements do not mean anything in the long term.
In fact, there’s so much similarity between value and contrarian investing that some consider value investing as an example of contrarian investing. And many legendary value investors are also considered contrarian investors.
These are some of the most famous contrarian investors.
That’s right – the most famous and arguably the most successful investor in the world is a contrarian. Warren Buffett never cared about what the media or analysts were thinking about the market or a particular stock. If he ‘felt’ a certain stock was a good investment, he would gladly invest a huge chunk of money, or sometimes, buy the whole company.
In 2008, for instance, at the peak of the financial crisis, when investors were losing their heads and their money amidst a wave of bankruptcy filings, Buffett told investors to buy American companies. He wrote on New York Times, and I quote –
“I’ve been buying American stocks. This is my personal account I’m talking about….If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.
Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful”.
Was he proven right? You bet he did. 10 years later, S&P 500 was up 130%.
He is an American billionaire investor and hedge fund manager, who is also the founder of Pershing Square Capital. He is also famous for using his equity stake in a company to put pressure on its management. Ackman has said that most of his successful investments have always been controversial, and his first rule of investing is to “make a call that nobody believes in”.
He twice reinvested heavily in beaten-down Valeant Pharmaceuticals against prevailing market sentiments.
Michael Burry is the man behind The Big Short (2015). In 2005, Burry bet against the riskiest parts of the subprime mortgage market and profited from them, when the housing market collapsed. Meanwhile, Burry and his hedge fund Scion Capital ended up producing nearly 500% returns for investors who stayed with him.
Dreman is the author of a number on contrarian investing including Contrarian Investment Strategy: The Psychology of Stock Market Success, and Contrarian Investment Strategies: The Next Generation.
Value investing is a contrarian approach you can start with. To kickstart your contrarian investing journey, check out our The 8-Step Beginner’s Guide to Value Investing.