How to Be a Contrarian Investor

Whenever you find yourself on the side of the majority, it’s time to pause and reflect.”
– Mark Twain

Contrarian investors believe that following the crowd leads to losses and missed opportunities. When the crowd reacts to news or speculation about a stock or the market, the price can rise of fall so far, that has mis-priced the value of the company or the market.

For example, a company finds it must recall a product due to a design or manufacturing problem. The recall causes widespread pessimism about the company and drives the price of the stock to new lows. The problem is real though the perception of the value of the stock is misplaced. Contrarian investors recognize these situations as opportunities. Once the selling is over and the company puts in place the necessary actions to correct the problem, the price recovers. Any investors who bought shares when the problem was at its worst, realize above average gains.

Similarly, widespread optimism often results in high valuations that cannot be justified by fundamentals. Eventually, the market recognizes the situation and the price falls. Again, contrarian investors try to avoid these highly hyped stocks, as the risk of a fall is greater than the reward of it climbing higher.

The contrarian investor looks to be part of the “smart money,” those few investors who recognize that crowd behavior tends to be wrong often. When the smart money players recognize this situation, they seek to benefit from the extreme sentiment expressed by the crowd. Bad news often overstates the risk and prospects of a company. Many investors will sell these shares in a panic to avoid owning the company’s shares. Contrarian investors identify and buy distressed stocks, selling them when the company recovers, leading to market beating returns.

In similar fashion, overly optimistic investors can drive up the price of a stock or the market to valuations that do not make economic sense. Eventually, these high expectations do not pan out and the price plunges. Contrarian investors are careful to exit or avoid these exaggerated situations. By going against the crowd, that has an unfounded belief in direction of the market, contrarian investors prepare to go the other way and avoid the losses the masses experience.

Deciding when to enter a contrarian trade requires a certain amount of fortitude and confidence. In 1999 and early 2000, the dot-com boom was underway. Many investors believe that the internet ass changing the nature of business. As a result, many of the fundamental and technical measures of performance were no longer valid. Along the way, many people bought into the market driving up the net capital inflows to all time highs. Much of this new money came from retail or non-professional investors driving up the NASDAQ. Once the inflow of new money tapered off, there was nothing left to support the extremely overvalued market. The market crashed.

Those who recognized that the market was overvalued were able to exit their positions. A few contrarian investors did not believe the hype. While many of them missed the run up, they also avoided the plunge. A few others maintained their trading discipline keeping their down side protection in place. When the market turned against them, they were able to exit their positions after enjoying the incredible run up.
The April 28, 2008 issue of Barron’s had an article titled “Back in the Pool.” They surveyed a number of professional investors to get an idea of their thoughts on the market. At the time the market had been in a rally that began in 2003 and was reaching what some thought were over heated conditions. Here are the results of the survey:

1) Describe your investment outlook through December 2008:

• Very Bullish: 7%
• Bullish: 43%
• Neutral: 38%
• Bearish: 12%
• Very Bearish: 0%

2) Is the U.S. stock market overvalued, undervalued, or fairly valued at current levels?

• Overvalued: 10%
• Undervalued: 55%
• Fairly valued: 35%

Essentially, there was a strong crowd mentality as the vast majority viewed the market favorably. By the end of 2008, the S&P 500 had fallen from a high in the 1400 area to 735 area. Those that stayed long saw their portfolios fall by more than 40%.

How to be a Contrarian

A contrarian investor does not always go against the crowd. Rather they look for situations when the market, a sector or a stock is significantly mis-priced. Along the way, they maintain their trading discipline keeping down side protection in place should the market change direction. Contrarians know they must not fight the prevailing trend. If the market is moving from the lower left to the upper right, they participate. When signs the trend is ending, they add more down side protection to their portfolios including reducing the size of their long positions.

Once the trend has turned and their trailing stops and protective puts have down their job, they look to find a new trend to follow. This can be a downtrend. They do not fight the trend. Rather they embrace it.

Contrarian investors look for situations when the market, sector, or stock becomes significantly overvalued or undervalued. These situations offer good entry or exit opportunities to capture additional profits. When an opportunity presents itself, contrarian investors complete their thorough evaluation before the make a commitment. Mis-priced opportunities arrive when people let their emotions take control over logic and analysis.

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The Contrarian Investor?

A lot of successful investors are contrarian’s. Regardless of the conventional wisdom, these investors look past the current market place, and see the future past the headlines. A current example, currently the oil business is in a free fall, oversupply and political manipulation, are to blame. Here’s the thing, does anybody believe that the world and it’s oil dependent economies are going to suddenly wean themselves of oil? Of course not! I have heard multiple talking heads proclaim that free fall per barrel price of oil to be $30.00 by summer. Here’s the point, enjoy it while you can! Low oil prices help the family budget, and better yet, an opportunity to the investor. Oil prices have created a ‘chicken falling” mentality, causing program traders, and the undisciplined investor to sell and cut and run.

The Contrarian Investor, on the other hand is sweeping in and buying U.S. drilling companies, and Canadian drilling and support companies at a fraction of their value 6 months ago. This includes support businesses in crucial areas as well. While the banks and “smart” investors are running, the infrastructure providers, to the oil boom, hotels and housing in the Bakken region, of North Dakota, and the West Texas, Permian fields, have great opportunities for the contrarian investor. At a devalued price, the result in earnings and value, when the table turns, will be dramatic. At one time during the previous financial depression, I saw a chance to buy Goldman, Sachs at $83.38 dollars a share. What is that worth now? It was obvious to me that not all financial institutions are equal. Time has proved that evaluation. Interesting point, the best days of gain in the stock exchange was the day AFTER the crash, 1929, the Regan crash, the 2008 crash all had record recovery immediately, the day afterward.

So what does the contrarian do? The philosophy is to take with a “grain of salt” all advice, paid or (even free!) and trust the long-term realities you know and believe in, then be aware of trends which defy what you have seen and experienced. Those are buying opportunities! Be quick and be disciplined! If you like a stock or investment after research, you buy that security, the next day, it falls of the board, what do you do, consider buying more. Your first impression was it was a good investment, if it falls a bit, price wise, it might be a great investment. Trust yourself. Follow blogs, forums, even mainstream news programs can give you a good start, sometimes by reading between the lines, See the counterpoint and don’t necessarily follow the short-term wisdom.

As always there are risks in investing, and all investments are not created for all investors. I suggest that seeking out your own investment, important to become fluent within the investment, its goals, its operation, its management. This will make you in charge, conversational on the topic, and comfortable. Make’s you an expert. You don’t have to know all about all investments, just your investments.

Investment Strategy: Contrarian Investing 101

Have you ever wondered why some people are able to invest in any financial instrument or property at a low price and why you have always missed the boat? This article explains the importance of understanding why contrarian investing works and how having such a mindset can help you make more money as part of a larger investment strategy.

1. Value Investing mindset

Before one can profess to be a contrarian investor, you must have an understanding of the underlying value of the thing you are buying and decide that it is undervalued and historically and the market will rebound within a good period. A good book to start reading on value investing in the stock market is “The Intelligent Investor”, by Benjamin Graham who was Warren Buffets’ Professor in Columbia University and helped shape his investment strategy. So because you know the usual market value of something, you can purchase it on the cheap when prices drop , not unlike shopping for discounts at a supermarket.

2. Look out for downturns

Another key indicator is to understand your market well and then pay a careful attention to downturns in the economy or freak incidents like September 11. Some investments do down in value due to macro economic factors that may have nothing to do with your particular investment. A contrarian investor would spend time looking for ominous signs in the papers which may lead to a downturn so as to purchase stocks, shares at a discount to the average price.

Downturns that can prove profitable include:

o Natural Disasters that have nothing to do with the underlying stock.

o Cross Border Disputes affecting a particular Company’s price which has nothing to do with its main operations.

o Wars and Hostilities that can affect the competitors of your current favourite stock.

3. Look out for excessive exuberance

Contrarian Investors know that downturns can also be profitable if you use Put options which pay you when the underlying stock declines in price? The best way to predict such a downturn would be to look for in the words of the former Chief of the Federal Reserve Allen Greenspan, “excessive exuberance”. This means basically that while prices are still rising furiously, the number of buyers would start decreasing and a market correction might follow.

Some indicators of such excessive exuberance include:

o When you see financial analysts being very rosy on highly speculative stocks.

o When the stock market indexes start rising close to record highs.

o When you notice that trading volume diverges with the price, meaning that while prices are rising, the trading volume is dropping.

Contrarian investing is thus a mindset where the individual looks for trading opportunities which can yield profits. A contrarian investor thus looks out for economic, political and other factors which can cause a large market movement in the particular financial instrument that he is trading in and can make a large capital gain from his investment. This form of investing can be part of a larger investment strategy and one should consider contrarian investing as part of his online investing warchest today.