Contrarian investing is an investment style in which investors purposefully go against prevailing market trends by selling when others are buying and buying when most investors are selling. A prime example is Berkshire Hathaway Chair and CEO Warren Buffett, a famous contrarian investor.
Contrarian investors believe that people who claim the market is going up do so only when they are fully invested and have no further purchasing power. At this point, the market is at a peak. Conversely, when predictions of a downturn are made, those making them have already sold out, indicating the market is primed to go up.
Key Points to Ponder
- Contrarian investing is an investment strategy that involves defying existing market trends to garner profits.
- The principle posits that markets exhibit herding behavior driven by fear and greed, making them periodically over- and underpriced.
- A contrarian sees opportunities in stocks currently trading below their intrinsic value.
- While it can be rewarding, contrarian investing is often risky and may take time to yield returns.
- A significant drawback of contrarian investing is the extensive research time needed to identify undervalued stocks.
Understanding the Contrarian Mindset
Contrarian investing implies a strategy of going against the grain of investor sentiment at a particular time. This approach can be applied to individual stocks, entire industries, or even entire markets.
A contrarian investor enters the market when sentiment is negative. The contrarian sees the market or stock as undervalued and seizes this opportunity. Essentially, excessive pessimism from other investors pushes the stock price below its true value, presenting the contrarian investor with a buying opportunity before sentiment improves and share prices rebound.
According to contrarian investors like David Dreman, news developments lead to overreactions causing overpriced ‘hot’ stocks and neglected ‘distressed’ stocks. This enables contrarians to buy undervalued stocks with potential for future growth.
Special Considerations for Contrarians
Contrarian investors often target distressed stocks, selling once the share price recovers and others start buying in. This strategy is based on the idea that herd instinct is not a reliable investment strategy.
However, this approach can result in missed gains if a broad bullish sentiment proves valid, leading to market rises even as contrarians have already sold. Moreover, undervalued stocks might remain such if market sentiment remains bearish.
Contrarian vs. Value Investing
Contrarian investing is akin to value investing; both seek stocks whose prices are below their intrinsic value. Value investors believe the market overreacts to both good and bad news, implying short-term price movements don’t reflect long-term company fundamentals.
Many value investors argue there is a fine line between their strategy and contrarian investing, as both rely on identifying undervalued securities using current market sentiment.
Legends of Contrarian Investing
Warren Buffett
Warren Buffett epitomizes contrarian investing with quotes like, “Be fearful when others are greedy, and greedy when others are fearful.” During the 2008 financial crisis, he advised buying American stocks amidst market turmoil and profited greatly as the economy stabilized.
Michael Burry
Michael Burry, a neurologist-turned-hedge fund owner, identified the subprime market’s overvaluation in 2005. His hedge fund, Scion Capital, shorted the most risky parts of the subprime mortgage market, yielding substantial profits. His story inspired The Big Short book and movie.
Sir John Templeton
Sir John Templeton founded the Templeton Growth Fund in 1954 and is noted for his contrarian strategy. An initial investment of $10,000 in his fund became worth $2 million by 1992, with dividends reinvested.
Limitations of Contrarian Investing
Contrarian investors face the challenge of identifying undervalued stocks, requiring significant research into stock fundamentals and market conditions. Opposing prevailing market sentiment alone is insufficient; solid fundamental analysis skills are necessary to assess a security’s intrinsic value.
It’s also common for contrarians to go through periods of underperformance, requiring patience until an undervalued stock gains appreciation. During such times, they may experience “paper losses.”
What Is Contrarian Investing?
Contrarian investing seeks profit by trading against current market sentiment. For instance, a contrarian would look to sell if the market is bullish and search for buying opportunities during a bearish market phase.
Noteworthy Contrarian Investors
Famed investors like Warren Buffett and Charlie Munger of Berkshire Hathaway are quintessential contrarians. Other prominent contrarians include David Dreman, Ray Dalio, Sir John Templeton, Michael Burry, and George Soros.
Using Deep Value to Outperform the Market
Deep value investing is often synonymous with billionaire contrarians who select stock investments based on a firm belief that a company’s stock is trading significantly below its intrinsic or book value. They acquire large stakes in such companies, anticipating a profitable price increase over time.
Note: The information provided is for educational purposes and does not constitute financial advice. Investment strategies should be tailored to individual goals and risk tolerance, and investing involves the risk of loss.
Related Terms: value investing, fundamental analysis, bull market, bear market, investor sentiment.
References
- Berkshire Hathaway Inc. “Chairman’s Letter - 1986”.
- Berkshire Hathaway Inc. “Chairman’s Letter - 2008”, Page 16.
- Yahoo Finance. “Goldman Sachs Group Inc. (GS) - Historical Data”.
- The Templeton Foundation. “Sir John Templeton 1912-2008”.
