Contrarian Investing

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Contrarian Investing

In finance, a contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong.

A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don't pan out. Avoiding investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether the investment in question is an individual stock, an industry sector, or an entire market or any other asset class.

Some contrarians have a permanent bear market view, while the majority of investors bet on the market going up. However, a contrarian does not necessarily have a negative view of the overall stock market, nor does he have to believe that it is always overvalued, or that the conventional wisdom is always wrong. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced. While more "buy" candidates are likely to be identified during market declines (and vice versa), these opportunities can occur during periods when the overall market is generally rising or falling.

Similarity to Value Investing

Contrarian investing is related to value investing in that the contrarian is also looking for mispriced investments and buying those that appear to be undervalued by the market. Some well-known value investors such as John Neff have questioned whether there is a such thing as a "contrarian", seeing it as essentially synonymous with value investing. One possible distinction is that a value stock, in finance theory, can be identified by financial metrics such as the book value or P/E ratio. A contrarian investor may look at those metrics, but is also interested in measures of "sentiment" regarding the stock among other investors, such as sell-side analyst coverage and earnings forecasts, trading volume, and media commentary about the company and its business prospects. In the example of a stock that has dropped because of excessive pessimism, one can see similarities to the "margin of safety" that value investor Benjamin Graham sought when purchasing stocks -- essentially, being able to buy shares at a discount to their intrinsic value. Arguably that margin of safety is more likely to exist when a stock has fallen a great deal, and that type of drop is usually accompanied by negative news and general pessimism.

Notable Contrarian Investors

Warren Buffet is a famous Contrarian, who believes that best time to invest in a stock is when shortsightedness of the market has beaten down the price.

David Dreman is a money manager often associated with contrarian investing. He has authored several books on the topic and writes the "Contrarian" column in Forbes magazine.

John Neff, who managed the Vanguard Windsor fund for many years, is also considered a contrarian, though he has described himself as a value investor (and questioned the distinction).

Mark Ripple is a money manager / author of Handicapping the Wall Street Way who has been described as a reverse-contrarian because of the way he finds bettable favorites at the racetrack.

Examples of Contrarian Investing

Commonly used contrarian indicators for investor sentiment are Volatility Indexes (informally also referred to as "Fear indexes"), like VIX, which by tracking the prices of financial options, gives a numeric measure of how pessimistic or optimistic market actors at large are. A low number in this index indicates a prevailing optimistic or confident investor outlook for the future, while a high number indicates a pessimistic outlook. By comparing the VIX to the major stock-indexes over longer periods of time, it is evident that peaks in this index generally present good buying opportunities.

Another example of a simple contrarian strategy is Dogs of the Dow. When purchasing the stocks in the Dow Jones Industrial Average that have the highest relative dividend yield, an investor is often buying many of the "distressed" companies among those 30 stocks. These "Dogs" have high yields not because dividends were raised, but rather because their share prices fell. The company is experiencing difficulties, or simply is at a low point in their business cycle. By repeatedly buying such stocks, and selling them when they no longer meet the criteria, the "Dogs" investor is systematically buying the least-loved of the Dow 30, and selling them when they become loved again.

When the Dot com bubble started to deflate, an investor would have profited by avoiding the technology stocks that were the subject of most investors' attention. Asset classes such as value stocks and real estate investment trusts were largely ignored by the financial press at the time, despite their historically low valuations, and many mutual funds in those categories lost assets. These investments experienced strong gains amidst the large drops in the overall US stock market when the bubble unwound.

Relationship to Behavioral Finance

Contrarians are attempting to exploit some of the principles of behavioral finance, and there is significant overlap between these fields. For example, studies in behavioral finance have demonstrated that investors as a group tend to overweight recent trends when predicting the future; a poorly-performing stock will remain bad, and a strong performer will remain strong. This lends credence to the contrarian's belief that investments may drop "too low" during periods of negative news, due to incorrect assumptions by other investors regarding the long-term prospects for the company.

David Dreman is on the Board of Editors of the Institute of Behavioral Finance.

See also

Value Investing

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