Don’t you hate those people who delight when everyone else is miserable? When others see only clouds, contrarian investors are focussed on the silver lining. It is during dark times like these that contrarian investors are on the prowl for investment opportunities that hopefully will see them outperform in the years ahead.

Contrarian investing is an investment style that is based on the premise that a stock or market is not going to move in line with what the majority of market participants are anticipating. Contrarian investors move against the crowd. They are independent thinkers.

Deep value contrarian investor John Templeton managed the Templeton growth fund from 1954 to 1992 and achieved an annualised return of 17 per cent over the period. He is quoted as saying, “The only way to get a bargain is to buy what most investors are selling. The time of most pessimism can be the best period to buy, and the time of maximum optimism can be the best moment to sell.”

Contrarians believe that fundamental and technical analysis can lead to consensus views of value which are not always accurate. Sometimes stock prices decline to levels that are excessively pessimistic and at other times they reach heights where the hype exceeds reality. Contrarians attempt to make a realistic assessment of a stock’s long-term earnings potential and then capitalise on opportunities where the price does not reflect this. This is similar to what a value investor does, but whereas a value investor is solely concerned with fundamentals, a contrarian is also looking to bet against the trend.

When the majority of investors are bullish, contrarian theory contends the market has reached a peak. Conversely when the majority are bearish the market has reached a bottom. Late 2008 and early 2009 saw doom and gloom reigning supremely. Contrarians are starting to get excited about potential out-performance opportunities.

When analysing a stock contrarian investors will need to take the following factors into account:

  • company fundamentals
  • a stock’s popularity
  • recent performance
  • investment time horizon

Contrarians need to assess a stock’s long term earnings potential by analysing its financial metrics. This includes assessing balance sheet strength, operating and financial ratios, earnings growth rates and dividend yields.

Unpopular stocks, ignored by the market, may present a contrarian opportunity as the market may be missing something. Often smaller stocks will not be well researched and trade at a lower price than their potential implies. A stocks recent performance also impacts the decision. Contrarian investors will be interested in buying stocks that have been performing poorly and selling stocks that have been performing strongly.

The investment time horizon needs to be long term. A stock that appears to be well away from equilibrium may remain that way for a long period before the market recognises it as such and starts to correct. It may also move further away from equilibrium before turning around.

For example in August 1987 the Nikkei 225 index was 25,700 trading at a PE ratio of 86 times. It appeared to be in a speculative frenzy. Despite that, it continued to rise another 50 per cent and peaked at over 38,000 in 1990. Had a contrarian shorted the index in 1987, they would have needed strong convictions and deep pockets to maintain their position for three years. Had they held on they would have been vindicated as the Nikkei then went into a 13-year slump and lost 80 per cent of its value.

Contrarian investing is only for those with strong convictions, patience, and solid funding.

Chris Batchelor is senior technical writer for Kaplan Professional.

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