Contrarian investing is an important strategy to consider if you are looking to broaden your horizons on strategies to grow your wealth.
In a nutshell, contrarian investing is an investment strategy that is marked by buying and selling contrary to prevailing market sentiment at the time.
Contrarian investing intentionally goes against the crowd when it comes to buying and selling securities.
Contrarian investing is distinguished from momentum investing, which is characterized by buying and selling in tandem with market trends.
As both names would imply, contrarian investing involves deliberately adjusting buying and selling behavior to go against the mainstream attitude and momentum investing is about following the mainstream attitude.
In this sense, contrarian investing and momentum investing can be seen as opposing investment strategies.
How Contrarian Investing Works
The idea of contrarian investing initially sounds counterproductive.
After all, why should you invest in trends that are the exact opposite of what is currently in demand? It seems that contrarian investing is a bad idea from the get-go.
Despite initial impressions, contrarian investing is a well-thought-out investing strategy that is employed by many successful investors.
The key idea that contrarians have picked up on is that they can buy assets when they are currently undervalued, and make a good profit when those assets come back into vogue. In other words, contrarian investing invests in out-of-favor assets that have a low price-earnings ratio, which they can then sell once the market turns around.
Here is a simple example.
Say Bob invests in stock in an industry that is currently out of favor—say beach towels. These stock initially have a low price-earning ratio which means Bob can pick up quite a few for a modest amount. As the summer comes around and more people want to start buying beach towels, the stock of the company that Bob invested in starts to grow. The value of this stock will rise greater than the rest of the market as the company expands and stock prices gain value.
The key insight behind contrarian investing is that group psychology causes individuals to misprice certain assets in the market.
In other words, the more people hop onto an investing trend, the greater the chance that the particular stock will be overvalued.
Contrarians intentionally buy undervalued stock and wait for the market to turn around where they then see large growth in their undervalued securities.
Contrarian investing can be applied to individual stocks or entire markets. Contrarians take advantage of the pessimism of other investors that have pushed down the prices of certain securities and buy that security before public sentiment recovers.
Contrarian Investing VS Value Investing
Contrarian investing and value investing, while not the same, share many similarities.
Value investing is an investment philosophy focused on identifying undervalued securities that have “intrinsic value” that gives them a sustainable competitive advantage over their competitors.
Value investing is the proclaimed investment philosophy of Warren Buffett (we cover that in-depth here), who is sometimes called the Oracle of Omaha for his incredible foresight in investing in successful companies.
So what does contrarian vs value investing have in common?
Both value investing and contrarian investing are centered on identifying and purchasing securities that are relatively undervalued compared to other market securities.
The main difference between the two is that value investing is focused on identifying the fundamental merits of a company; things like leadership, worker innovation, and market niche that give it a long term advantage over competitors.
Contrarian investors instead look at more technical or subjective factors, like indicators of undervaluing or poor media reception.
Contrarians want to find securities that are both oversold and undervalued whereas value investing is focused mostly on undervalued securities.
Contrarian Investment Strategies
We should be clear here; being a contrarian just to be a contrarian is not a good idea.
Making contrarian investments does not guarantee that you will see good returns. The key feature that makes a successful contrarian is that she can make good decisions and be correctly contrarian. Being correctly contrarians means that you do not just pick unpopular stocks but incorporate a solid fundamental analysis that takes into account how investors are prone to overreact.
The Dreman Methodology
The Dreman methodology is a contrarian investment strategy pioneered by David Dreman in his book Contrarian Investment Strategies: The Next Generation.
Dreman’s strategy involves identifying 4 key variables that gauge the strength of businesses; earnings, cash flow, book value, and dividend yield.
The key with the Dreman Methodology is to pick stocks that fall in the bottom 20% of the market for at least 2 of the 4 key variables.
The stocks you pick should also be from among the 1,500 companies with the largest market capitalization as larger companies have more staying power and are more in the public eye.
Out of the 4 major key variables, the most important one to gauge is probably the price-cash flow ratio. A low price-cash flow ratio is a good indicator that a company is performing well but is currently undervalued in a market.
The Dreman Methodology is about taking advantage of surprises in the stock market.
Surprises happen all the time with stocks, and those who have well-performing stocks get the least amount of benefit from a positive surprise because they are already doing well.
Conversely, those who have underperforming stock can benefit greatly from a positive surprise in a market, while being less detrimentally affected by a bad surprise. So contrarian investing strategies put you in the optimal position to reap the largest benefits from an upturn in the market and insulate you from the worst effects of a downturn in the market.
It should be noted that this portfolio strategy will have periods of good returns, but also likely have long periods of underperformances.
Contrarian investing requires a bit of patience. You have to give the market time to turn around and have your stock value recover.
Read More: Momentum Investing Strategies 101
Another contrarian strategy is known as contrarian option-selling.
Contrarian option selling involves selling cash-secured put options so you get paid to essentially insure the losses of others.
Here is how this works:
Say some company is currently trading shares at £48 a share.
You want to buy the shares at an even lower price though, so you sell a put option at a strike price of £45 that expires in 7 months. You can then get paid an option premium (let’s say £3) to take on this obligation to buy the stock if it dips under a certain value.
If the stock stays above £45, then you keep the £3 premium share and can sell other options. If the value dips, you will be paying an effective £42 per share (£45 per share + £3 premium for each share), which is a good deal lower than the current market value of £48.
So with contrarian option selling, you can handle it in two ways.
You can sell put options in companies that you expect to do well, and gain from the premium payments.
Here you are intentionally betting that a successful company will not fail so you can get premium payments.
Alternatively, you can get paid to take on the obligation to sell shares if they dip under a certain value. Say you have stock in a company that is worth £33 a share.
Based on how that stock has grown over time, you may conclude that the stock is overvalued. You can sell a covered call at £30 a share and receive a call option premium of 2£ per share.
If the shares stay under £33, you keep them and the 2£ premiums and any dividends. If the shares go over £38, you keep dividends and sell at £38 a share, freeing up money to invest in other undervalued companies.
So contrarian option-selling is about going against the mainstream sentiment by insuring companies that are not likely to fail.
By selling a put option, you can insure investors for their losses and come out ahead in the stock remains high value.
Contrarian Investing: Summary
Contrarian investing is not necessarily new, but it has received a lot of public attention in recent years.
One thing that contrarian investors tend to stress is to not listen to experts. While “expert market analysts” often have a great deal of technical knowledge, they have a tendency to overestimate their abilities, which leads to behavior that overvalued stock.
Many contrarian investors, such as David Dreman, explicitly tell would-be contrarian investors to disregard the experts and use your intuition. Sometimes in investing, it helps to have an outsider eye that is not tainted by the prejudices and assumptions of those experienced with investing.
For example, physician turned amateur investor Michael Burry is an oft-cited example of the successes of contrarian methodology, as he was one of the few that identified and profited from the subprime mortgage crisis.
Burry intentionally went against the mainstream investment sentiment and correctly predicted the crash of the housing market. He bought several credit default swaps against subprime deals and profited accordingly when the market crashed in 2007.
So sometimes going against the grain is the right idea.
With the right contrarian eye, you can catch trends in markets that others may not notice, and profit accordingly when things turn around. The main thing to focus on with contrarian investing is to keep your eye to the future. You may see periods of long underperformance, but over time these can be compensated for by gains.