Humans are prone to herd because it is always warmer and safer in the middle of the herd. Indeed, our brains are wired to make us social animals. We feel the pain of social exclusion in the same parts of the brain where we feel real physical pain. But that’s not good for an investor.
Philip Fisher used to say that be extra careful when buying into companies and industries that are the current darlings of the financial community. This strategy is known as contrarian investing.
Michael Burry, who is famous for betting against the subprime mortgage market in the mid-2000s, is a contrarian investor and the subject of a book and film both entitled The Big Short. He and his hedge fund, Scion Asset Management, continue to make contrarian investments.
Contrarian investing means holding a viewpoint on the market that is out of favor. And then doing the necessary study to determine if there’s an investment opportunity. That is the reason the tribe is less in numbers since successful contrarian investors must be willing to spend a lot of time evaluating market conditions to build their case.
If the prevailing market sentiment is that the pace of economic growth will accelerate, for instance, spurring more market gains, a contrarian could decide to make investments predicated on the idea that the economy won’t accelerate, and that stock prices will decline.
It may take an investor weeks or months to fully develop a contrarian viewpoint, and even more time for their strategy to pay off. Contrarian investors must be comfortable with the risks and potential losses that come with waiting. By making investment decisions that align with a contrarian view—and doing so early—contrarians aim to make trades before the consensus view shifts in their favor.
A contrarian investor looks for opportunities where the popularity of an investment choice in the broader market has led people to drastically misprice certain securities. That means when everyone else is buying a certain stock, the contrarian is selling. When everyone’s selling out of a certain industry, the contrarian is picking up shares on the cheap.
Contrarian investors assess prevailing market conditions and overall investor sentiment, and when sentiment leans heavily in one direction, take the opposite side of the trade. Contrarian opportunities typically present themselves when investors rush into certain sectors or asset classes, in part by selling portions of their other assets in order to raise the capital necessary to invest in the currently favored industries.
For example, tech stocks have been in favor over the past few years. Meanwhile, energy stocks have had some of the worst returns of any sector. The contrarian has likely sold all of their tech stocks and bought a lot of energy stocks.
A contrarian investor thinks a lot like a value investor. Both seek to buy shares of stocks when they’re trading below their intrinsic values. But contrarians, more so than value investors, are comfortable with companies’ stocks trading below their intrinsic values for long periods of time due to unfavorable market sentiments.
A key component of contrarian investing is becoming fully invested in a sector or asset class as sentiment about that type of investment improves. Then, once most people are excited about the investment, contrarian investors recognize the growth of their holdings is soon likely to slow. Anticipating that their investments may begin to underperform the broader market, which could negatively impact investor sentiment and potentially lead to even greater price underperformance, contrarian investors sell their holdings to begin investing in currently unpopular industries.
“It’s not always easy to do what’s not popular, but that’s where you make your money. Buy stocks that look bad to less careful investors and hang on until their real value is recognized. I’ve never bought a stock unless, in my view, it was on sale. Buy on the cannons and sell on the trumpets.” – John Neff
And Here It Differs From Value Investing
Contrarian investing is a form of active investing, since contrarians seek to outperform the market rather than keep pace with the market’s gains. Contrarian investing also aligns more closely with long-term investing than day trading, because contrarians often have a timeline that’s weeks, months or years long.
Contrarian investing may see the most overlap with value investing. Both approaches seek out opportunities that have been overlooked and mispriced by the majority of investors. Both are seeking stocks that are underpriced, or where the share price is below their estimate of a company’s intrinsic value..
Finally, contrarian investors may find themselves aligned with short sellers who bet on falling prices by “shorting” a stock—or profiting on a stock when its share price declines. Even so, contrarian investors typically have a longer timeline than short sellers, and are equally as focused on investment opportunities that require asset prices to rise.
The advantages are:
- Buying stocks when they’re out of favor creates a considerable margin of safety relative to the stocks’ intrinsic values, theoretically reducing downside risk.
- Your portfolio is more likely to outperform the market on a long-term basis as a contrarian investor.
The disadvantages include:
- It’s psychologically challenging to remain committed to an investment in the face of overwhelmingly negative sentiment about the investment.
- Contrarian investing requires creative thinking, market expertise, time devoted to conducting research, and the prioritization of long-term outlooks. It’s a rigorous practice that takes years to master and an investing style that can be easily derailed by the influence of short-term noise.
- Your portfolio will likely underperform, perhaps for a long period of time, before your contrarian investment strategy starts to pay off. You can also miss out on expected gains if market sentiment shifts for legitimate reasons in a way that further delays your long-awaited payoff.
John Templeton has summarised it well:
- To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit.
- Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.
- If you want to have a better performance than the crowd, you must do things differently from the crowd.
“A business or stock is not an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right. I will tell you how to become rich…Be fearful when others are greedy. Be greedy when others are fearful.” – Warren Buffet
