"Be contrarian" is one of the most widely quoted pieces of investment advice out there. It's also incredibly unhelpful. Most of us know that we should "go against the crowd" to achieve superior investment returns. All the great investors say so. Warren Buffett tells us to "be fearful when others are greedy and greedy when others are fearful" and John Templeton advises us to "buy at the point of maximum pessimism". You'll never hear a fund manager plug his fund by saying: "I stick as close to the herd as possible that's how you make the big bucks."
But how do you know if a contrarian investment will pay off? And how do you know what the market is thinking in the first place are you really being contrarian, or have you simply misjudged the market's mood? Here are some tools you can use to develop your own contrarian strategies.
Why contrarian investing works
The stockmarket is dominated by professional investors who, on the whole, derive a great deal of comfort from staying with the consensus. An active fund manager who wants to keep his job might never admit it, but it actually makes a lot of sense for him not to stray too far from the crowd. Fund managers are largely benchmarked relative to other indices and to each other. As a result, straying too far from the benchmark means taking huge risks with your career you might beat your peers by a long way, but similarly, you might underperform badly.
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This often results in a strategy of chasing winners and dumping losers and makes the market as a whole susceptible to periods of extreme optimism and pessimism. Being able to spot these trends and exploit them is at the heart of contrarian investing.
As a private investor, you fortunately don't have to worry about career risk. But going against the crowd can be a lonely experience, requiring total conviction in your strategy. It can take a long time for stocks to revert to their intrinsic values. And the consensus isn't always wrong.
However, by constantly questioning the prevailing consensus, you are at least testing assumptions that many others just take for granted. And by testing them, you are more likely to come up against situations where the market's assumptions are simply wrong. These often provide the best opportunities over the long run.
But when do these sorts of situations tend to arise? Pessimism affects both markets and individual stocks. Markets have historically shown signs of extreme pessimism in times of war or political and financial crisis that triggers a wave of selling activity. On a smaller scale, companies that are subject to adverse temporary influences, such as weather or litigation, can see their shares sold down to bargain levels. Both instances tend to create scenarios where there are lots of sellers and few buyers, which can create an ideal situation for long-term investors.
Five ways to spot a contrarian bet
1. Historic lows
Look for stocks trading at or near all-time or 52-week lows this is often the first sign of an opportunity.
2. Valuation ranges
It's worth looking for stocks that have a low price/earnings (p/e) ratio, a high dividend yield and a low price-to-book (p/b) ratio. But remember to check: have these valuations been more extreme in the past? Looking at these valuations over, say, five to ten years will give you an idea of how much pessimism is really priced into a stock.
3. Shiller p/e
This looks at the share price compared with earnings averaged over the previous ten years. A stock trading at or near its lows on this measure is historically cheap and may be an opportunity.
4. Technical analysis
The use of charts is often criticised in the investment world. But they can be of great use to contrarian investors when timing their trading. Many successful traders look at moving averages of share prices (eg, the rolling 52-week average share price) in deciding when to buy or sell. For example, if a share price is falling and the moving average share price is falling too, that suggests a downward trend. A trader might wait until the share price has risen above the moving average seeing this as evidence of improving sentiment towards a stock before purchasing it. The reverse scenario would apply to a stock where the price has been rising.
5. Analyst 'buys' and 'sells'
Numerous free websites give information on stock broker recommendations. When all broking analysts have 'sell' recommendations and no 'buys', then this can represent a great contrarian opportunity.
Avoid value traps
Just because something has fallen in value it doesn't mean that it will automatically rise again. Following these four rules may save you from buying a company that is cheap for a reason.
1. Is the fall really temporary?
Satisfy yourself that the share-price fall is due to temporary factors, such as weather, litigation, or a low-point in the business cycle and that the company's profits, and investor sentiment towards the company, can recover.
2. Look for financial strength
Make sure that debt and other long-term liabilities are not excessive and that any interest payments can be comfortably met.
3. Get paid to wait
Patience is a virtue, particularly when it comes to contrarian investing. Buy stocks that pay decent, well-covered dividends, with the scope to grow.
4. Diversify
Buy contrarian investments across a number of sectors to spread your risk and the timing of any payoffs.
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