Contrarian Investing

So what is contrarian investing and who is a contrarian investor?

The answers are probably much more broad than you'd think. Many investors incorporate contrarian plays into otherwise conventional portfolios and many contrarian plays are based on common sense, value investing principles.

A contrarian investor is someone that shuns market trends and hyped investments. While other investors are jumping into a hot stock and chasing after gains that have already come and gone, a contrarian investor sees it as a reason to avoid the stock altogether. The contrarian aspect of the term is derived from solely from perspective. The underlying logic is pretty simple. If a lot of investors are going after shares of the company, it is going to quickly become overbought and share prices will no longer reflect the actual strength of a company.

Inevitably, overbought companies that are all over the news will see their shares drop in value as the share price to earnings ration drops to a reasonable level.

For the investors following popular and “conventional” strategies who were chasing after gains they missed, this will inevitably result in a loss as a correction occurs and confusion on why the strategy worked for others and failed for them.

To avoid this boom-and-bust cycle that many investors find themselves in, a contrarian investor is looking for the undervalued — but otherwise healthy — underdog that everyone else abandoned to hop on 'the next big thing.'

This isn't a bearish move. In fact, most contrarians are quite bullish about the companies they choose to invest in. It is all about getting into a position before anyone else notices that it is a strong play and before everyone else hears that they should be buying up shares and driving up the price. 

In this sense, there is no single method or set technique for contrarian investing, but there are some basic themes that are universal. It is all about how a stock is evaluated as a potential portfolio position. 

It certainly isn't an all-or-nothing strategy either. It can easily be integrated as part of a portfolio that stresses growth, income or value investing or mostly index-based funds. 

That will minimize the downside risk of price corrections and minimize the effect of large institutional investors milking small investors for profits because they can outmaneuver them in the market.

How To Be A Contrarian Investor

Like many investing strategies, contrarian plays require strong research while stressing impartiality and discipline.

Contrarian investing often best when an investor has thoroughly analyzed the fundamentals of the companies they invest in. There is no need to rush while you do your due diligence. After all, these are the kinds of companies virtually everyone else is ignoring.

As you research the company, you should be looking for a solid management team, innovative products, efficient processes, and good profit margins. Companies that can maintain these fundamentals can weather downturns and unpopularity with investors while they continue to run their business as usual. 

You should also be wary of trusting reports from analysts. They are often overly optimistic. At the same time, companies often try to low-ball earnings to try to calm down overly enthusiastic analysts. If they can pull that off, they'll get some good press about “beating earnings expectations.”

Price to earnings (P/E) ratios should be considered but taken with a grain of salt. The figure has two variables that can easily change. Current share price is one and the quarterly earnings figures are the other.

If earnings are rising quickly over time but current earnings are relatively low, the ratio will be high. At the same time, if share prices are stable but the company's earnings are tanking from bad products or sales, the figure is about to skyrocket.

In the end, a contrarian investor is better off digging deeper to see how earnings may evolve over time and how well the management team has used their assets to make a healthy profit and grow their business.

A strong management team that has posted profits every year by adapting their operating costs to current conditions, through good times and bad, is worth its weight in gold. They'll know how to adapt to evolving business climates and how to pull as much value out of their company for shareholders.

You Still Have To Be Very Careful…

As with any strategy, contrarian investing has its flaws and common pitfalls you'll want to avoid:

1. Having too much information can lead to the perception that you know what will happen. This will set you up for confusion and disappointment.

2. Correlations break down as quickly as they appear. If oil is expensive, focus on how an oil company will do even when oil is cheap. Oil companies may see a bump from higher oil prices, but that will come to an end and it will be nearly impossible to predict.

3. It is impossible, with constantly changing political, economic, and competitive conditions, to predict the future with data form the past. It is just a point of reference for estimates and for the competence of management.

4. You still have to be realistic about the downside of an investment. That often means you'll have to tone everything down even when you think you are right. Expect the worst to be more severe than you'd expect.

The last pitfall cannot be understated. As John Maynard Keynes once said, “Markets can remain irrational longer than you can remain solvent.”

It is critically important to find companies that are doing well enough to keep going when they are weak. Don't depend on the next quarterly earnings to salvage a company that is down and out. It may not happen for a long time. At least when it does, you'll make up for lost time with a strong gain.

Contrarian Investing Perks

A perk of contrarian investing is the effect of positive and negative news, especially earnings reports. Often times, positive news will give under-appreciated stocks a large boost while negative news will result in a small drop. There aren't going to be a lot of skittish investors holding shares, so there won't be a bunch of panicked individual investors dumping shares as quickly as possible.

The inverse is true for hyped, overbought companies. Tech stocks are notorious for it. Just look at Microsoft years ago, or Apple in late 2012 and early 2013. Some bad earnings reports and news of slipping market share tanked stock values. When good news was released, the boost was not proportional to the drop from bad news.

If you incorporate some contrarian investing techniques into your portfolio, you'll have relatively safe positions with upside potential and won't have to worry about the hype that has fueled losses for countless traditional investors.

Wealth Daily's editors are constantly looking beyond the mainstream media hype to find real value in the market. Stay tuned to learn about overlooked and unconventional ways to confidently invest and capture gains, whether we're in a bearish or bullish market.