Some of the greatest investors of all time made the majority of their returns by taking the opposite approach to what to buy or when to sell it. Some may say it is the only way to beat the market. But how is it done?
Contrarian investing is the practice of taking the opposite action to the market sentiment; buying when the majority are selling and selling when the majority are buying. It takes advantage of market mispricing; buying stocks when they are undervalued, similar to value investing.
What is contrarian investing?
Contrarian investing is an investment strategy that focuses on taking an opposite approach to the prevailing sentiment, usually buying equities that are unloved by the general market and often selling when very popular. The strategy is founded on the belief that investors commonly act as a herd and all share a similar mentality about certain stocks; this creates mispricing in the equities market. If most investors believe a company will face difficulty in the near to long-term future, many will sell the stocks, often driving down the price beyond what is fair value, making it cheap. Buying stocks when they are oversold can increase the chance of above-average gains. On the other hand, if a stock becomes very popular, investors can drive up the price beyond what is fair value making the stock expensive. This is an opportunity for the contrarian investor to sell for an outsized profit.
Contrarian investing is very similar to value investing; both are looking for inefficiencies in the market and seeking to buy undervalued equities. The only difference is that contrarian investing focuses more on stock sentiment, whereas value investing is less concerned with what other investors think, more if they deem the stock to be cheap based on fundamentals. Although, emotion still plays a role. Warren Buffett, the most successful value investor of all time, said, “Be greedy when others are fearful, and fearful when others are greedy.” The correlation is that stocks with negative sentiment are often cheap from a fundamental point of view. The value investing philosophy centers around purchasing assets at a discount to their intrinsic value, also known as buying with a margin of safety. In other words, you look to buy a dollar for fifty cents. It requires a great deal of discipline and patience to find these bargains.
Is contrarian investing profitable?
Contrarian investing is arguably the most profitable way to invest. By its very nature, investors are buying equities that are cheap and selling expensive equities. There is no better way to build wealth. Suppose we want proof that contrarian investing is profitable. In that case, we only need to look at the best investors of all time.
Warren Buffett
Warren Buffett is arguably the greatest investor that has ever lived. He is not only the greatest ambassador for value investing but also further refined and improved the original value investing model laid out by Benjamin Graham. Instead of just looking for the most discounted companies, Buffett also took the quality of the business into consideration. Put simply, instead of going into a store and looking for what items were the most discounted, Buffett would visit the store every day and wait for his favorite items to go on discount before buying.
From 1965 to today, Warren Buffett has been running Berkshire Hathaway, a multinational conglomerate through which Buffett has made all of his purchases. In that time, Berkshire has a compound annual return of 20.1% against the S&P 500’s return of 10.5%. If you would like to know when is a good time to buy Berkshire Hathaway stock just watch out for when Buffett buys back some shares; this is usually an indication the stock is underpriced.
Howard Marks
Howard Marks is the Chairman of Oaktree Capital Management from its founding in 1995. Marks focuses on value investing as well as knowledge of human psychology to outperform the market. He is a strong advocate of deep thinking; where more consideration is given to investment compared to the average investor. To have above-average returns you have to diverge from the crowd. You also have to play devil’s advocate to every thought you have.
Since the firm’s founding, Marks has produced a compound annual return of 18.8% compared to the S&P 500’s annual return of 10.4% during the same period. Investments include preferred stocks, convertible bonds, and debt.
Sir John Templeton
Sir John Templeton is one of the first renowned investors to adopt value investing. He ran the Templeton Growth Fund which took the approach of investing globally in countries that no one would dare go and taking a contrarian bet when an investment looked too ugly to buy. He is known for investing heavily during World War II, market cycles, and depressions.
From when Templeton founded Templeton Growth Fund in 1954 to its closing in 1992, the fund returned a compound annual rate of 15% while the S&P 500 returned 11.1% during the same period.
How to become a contrarian investor
To become a contrarian investor, you must spend time conducting research and analysis, focusing on long-term outcomes, and staying within your circle of competence. It requires a lot of patience and the right temperament not to be influenced by sensational media or the opinions of others.
Contrarian investing requires patience
The great thing about investing is that it does not require you to reach a quota of investments for a given year. You can look at 10’s or even hundreds of companies before finding one you deem suitable for purchase. The opportunity has to be just right- a great company that the investor can understand, at a great price, and is better than any other opportunity they can find. When attractive opportunities are abundant, such as in a stock market crash, the investor must find the most attractive one. When opportunities are rare, such as in an extended bull market, the investor must exercise great patience and wait for an opportunity to come. An investor may only find one good opportunity a year, or they may find ten.
Contrarian investing requires buying with a margin of safety
The goal of value investing is to buy a dollar for fifty cents. This not only means you are getting more value than what you paid but also provides a buffer for valuation mistakes, making you less likely to experience loss. Because valuation has a certain level of impreciseness, investors need a margin of safety. It is similar to an elevator; the elevator may be able to carry 2,000 lbs., but you only want to have it carry a maximum of 1,000 lbs. to ensure you are well within its tolerances. Thorough research and analysis are needed to discover these mispricings.
Contrarian investing requires long-term thinking
It is important to remember that stocks represent tiny pieces of a company. They are not just numbers moving up and down on a screen. When buying a stock, you technically become a part-owner of a business, but without the responsibility of the day-to-day running of that business. This business owner is also the mentality investors should adopt when buying a stock. In the same way a farmer does not think about selling their farm one day in the hopes of repurchasing it next week at a profit, the investor should be a long-term owner. Investors need to be comfortable with the idea of the stock market closing for ten years after they purchase. If you are confident the business will increase in intrinsic value over the long term, this holding period should not bother you.
Contrarian investing requires staying within your circle of competence
To have an edge in investing, you have to think about the areas where you have an advantage over other people. It is no use working in an area where others a smart and you are stupid. Focus on areas where you know a lot, and stay within your circle of competence. The size of the circle is not important; knowing where the boundary is. This awareness helps you avoid problems and identify opportunities. This doesn’t mean you do not stop learning; quite the contrary. Investors need to continually be working on expanding their circle of competence by being life-long learners. It would help if you chipped away at the edges by learning something new daily.
