Introduction
There are two main schools of thought when it comes to investing: some investors prefer to follow long-term trends by investing in indices, while others try to find investments that the market is mispricing by employing a contrarian strategy. Contrarian investing involves buying assets that the market currently does not favor, with the hope that the market will eventually recognize the true value of the asset over time.
What is Contrarian Investing?
Contrarian investment strategies aim to buy undervalued assets and sell them when they regain favor in the market.
For example, a contrarian investor might buy a stock in an unfavored sector – such as energy – with a low profitability ratio. As sector rotation occurs and energy prices recover, the profitability ratios of companies in that sector will increase due to greater growth prospects. The value of the energy stock for the investor will rise more than the overall market thanks to expanding profitability and increasing earnings.
The core idea behind contrarian investing is that collective psychology often leads to mispricing of assets in a particular market. There is ample evidence of this behavior following earnings announcements when companies often experience significant price fluctuations early in the day before stabilizing by the end of the day. For example, a stock price may drop significantly right after the market opens and then recover some amount immediately.
Contrarian Investing vs. Value Investing:
Contrarian investing and value investing are similar in that both seek to identify securities that are undervalued before they are recognized by the broader market. For instance, both strategies may look for opportunities by seeking favorable financial indicators that suggest a stock is relatively undervalued compared to the overall market. Some experts, like renowned value investor John Neff, believe the terms may be synonymous.
The main difference is that value investing focuses exclusively on fundamental merits, such as financial ratios or the present value of future cash flows. In contrast, contrarian investors will also look at technical factors – such as heavily shorted stocks – and subjective factors – like negative media coverage. Contrarian investors seek assets that are heavily sold off and undervalued rather than merely those that are undervalued.
Finding Contrarian Investments
There are many different strategies that can be used to find contrarian investment opportunities, including various forms of fundamental and technical analysis.
Fundamental Strategies:
The most common contrarian investment strategies early on involved finding stocks with low price-to-earnings ratios, low cash flow ratios, low book-to-value ratios, and low profit margins. Generally speaking, these companies tend to be out of favor compared to companies with higher financial ratios since the market values them at lower multiples. Investors may also look at volatility indicators, such as the VIX index, and buy assets when the market is overly pessimistic.
The “Dogs of the Dow” strategy is perhaps the most famous contrarian investment strategy, involving buying the highest yielding stocks in the Dow Jones Industrial Average. Often, this means that the investor is purchasing companies that have been most affected due to price declines.
Technical Strategies:
Many contrarian investors also incorporate technical analysis into their decision-making process, analyzing the strategy based on financial behavior factors that can be quantified. For example, a contrarian strategy might involve buying stocks that have a relative strength index that has dropped below 30.0 points, indicating oversold conditions. The goal is to take advantage of a potential return to the mean that may occur.
Contrarian
International
The principles of contrarian investing can be applied to international markets by investors looking to buy in countries or regions that are undervalued relative to their actual worth.
It is common for entire countries or regions to fall out of favor over time. For example, the European sovereign debt crisis that began in 2008 led many investors to avoid European stocks, resulting in a significant drop in profit ratios. Had investors bought Greek or Irish stocks at the height of the crisis, they would have seen substantial returns on those investments. The same applies to Asian investments during the Asian financial crisis in the 1990s.
In addition to specific events that cause valuations to decline, investors can also look at the country’s economy to determine whether it is undervalued or overvalued. Warren Buffett famously looks at the total market capitalization of a country divided by its GDP. Countries with a ratio above 90% tend to be seen as undervalued, while those below 75% may be overvalued. This can be a great starting point for investors looking for opportunities abroad.
International contrarian investing may be particularly beneficial when local securities appear to be overvalued across the board. In this case, a local contrarian investor may struggle to find many opportunities without looking overseas.
Conclusion
Contrarian investing seeks to invest in assets that are out of favor and sell them when they return to popularity. There are various fundamental and technical strategies that can be employed to achieve these goals, while investors may also want to look beyond the United States to find the best opportunities.
Source: https://www.thebalancemoney.com/what-is-global-contrarian-investing-4151949
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