The Lonely Art of Contrarian Investing

Monday, June 7, 2010

Imagine that when the internet bubble peaked on March 15, 2000, you had already begun moving out of high-flying, technology stocks into stagnant, “old economy” ones. Or, when the market bottomed on March 9, 2009, you were already moving into actively managed stock funds. A pipe dream? No – it’s the result of successful contrarian investing.

So, how do you get some of that? It’s a challenge, but can be done with understanding, practice and time. It’s well worth the effort, because contrarian investing is one the best ways to control risk and produce return – and provide emotional well being.

Personal note: I have explained contrarian investment decisions throughout my career to fund boards, management, staff and investors. I have found, as the CFA program describes, that contrarian investing is one of the most difficult subjects for investors to grasp. The comments to my article, “Time to Be a Contrarian,” at Seeking Alpha, illustrate that fact (see comments here).

Part of the problem probably lies with the label. “Contrarian” can imply being “contrary” or “ornery” – i.e., anti-everything – where the opposite course is always the best. A better description is healthy skepticism.

Contrary investing is not an everyday occurrence. The major trends usually remain in place for long periods of time, reflecting what’s happening to the economy, financial measures and company results. But, there comes the time when conditions create extreme reactions, increasing risks and/or increasing return opportunities. This is when contrarian investing is needed. Here are the five steps I believe are key to having success.

Step 1. Analyze objectively:

  • Look forward only. Don’t rely on facts that are known to everyone. This is not “news” – it is past information that is already in the stock market. The market will rise or fall on what will happen, not what we already know.
  • View data without media commentary – Go beyond the surface numbers, and apply sound analysis. Do not let the media determine the meaning or importance.
  • Do not use trend continuation lines – Beautifully straight lines (or wiggly ones) mean nothing without supporting information.
  • Be agnostic – Ignore politics or generalized descriptions of the US, the world, Wall Street or any other body. Open democracies and capitalist economies are noisy and messy. That’s life – and not a determinant of investing success.

Step 2. Watch how news and market moves are interpreted

Evaluate media reports and watch investor reactions, looking for times of similar, breathless articles and sharp market moves. These are indicative of excess.

Step 3. Measure what investors are doing

Look for investor flows (both individual and institutional) becoming significantly unbalanced (by both size and length of time). Such conditions can create valuation opportunities and risks.

Step 4. Listen to your emotions

The advice, “trust your gut,” works in reverse in investing. Every investor, no matter how experienced, has to deal with the same human emotions in an extreme market environment. When conditions fairly scream, “Buy! Money for the taking!” or “Sell! Big losses ahead!”, feelings of over-optimism (greed) and over-pessimism (fear) can take over. Experience can teach investors to use such feelings as indicators of the time to think contrarian. An experienced investment manager said it well:

“The best time to buy stocks is when you hear the term, ‘stock market,’ and you want to throw up.”

Step 5. Be cautiously active – and realistic

Expect to miss the bottom (or top). Emotional periods can produce outsized rises and declines (popularly called “black swans” and “fat tails”). Normal valuation ranges can be exceeded as greed or fear drives buying or selling. So, when you spot such a period, be cautious – but do act.

Acting in steps (like dollar-cost averaging) is good, allowing the taking advantage of strong moves that provide attractive prices (e.g., last Friday’s sell-off). A wholesale portfolio shift occasionally works, if risk is controlled, but usually stepping in or out in an orderly manner will produce both the action needed and the confidence to see it through if the market doesn’t immediately turn.

An important bonus payoff

Getting in (or out) when a major trend turns puts an investor “in sync” with the market. Being there provides a valuable viewpoint and a better understanding of what’s happening and why. Investors who don’t make the move are left to “fight the tape,” scratching around for news and opinions that support a rebirth of the previous trend.

So… Developing an understanding of contrarian investing can be valuable, both for controlling risk and generating good returns. Just don’t expect family and friends – or even your financial adviser – to endorse the move beforehand.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

June 2010