Contrarian investing and what it is

M1 Team
M1 Team July 18, 2019

What is contrarian investing?

Contrarian investing refers to a strategy of investing in which the investors go against the trends that are followed by the majority. Contrarian investors buy or sell shares when the majority of investors are doing the opposite. Typically, the investors who engage in contrarian investing do so with a long-term view.

This strategy can be used with stocks, with an entire industry sector, or with bull markets or bear markets. A bear market occurs when there is a downward trend in the market that lasts for a longer time period than a stock market correction. By contrast, a bear market occurs when the market continues to climb.

Who are some famous contrarian investors?

There are several famous investors who have engaged in the practice of contrarian investing. Warren Buffet says that the opportune period to invest in a stock occurs when the market trends have caused the price to drop. He says that people should “be greedy when others are fearful”.

David Dreman, publisher of Contrarian Investment Strategies: The Next Generation, thinks that investors exaggerate because of the influence of media. This causes popular stocks to be overpriced while the earnings of lower-value stocks are underestimated. This causes limited upward prices and sharp falls for stocks that are on fire, opening up the opportunity for investors to pick up undervalued stocks to add to their asset class mixes.

Michael Burry determined that the subprime market was incorrectly priced and overly emotional. Burry owned Scion Capital, which shorted and profited from the subprime mortgage market. The Big Short was written by Michael Lewis and has been made into a movie that documents this contrarian investing move.

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Financial markets statistics, U.S. investors

Between 2008 and 2016, the percentage of Americans who were invested in the stock market fell from 62% to 52%. Among people who are currently invested in the stock market, 50% have less than $40,000 invested in their asset class mixes.

Among people who are not invested in the stock market, 21% say that they do not trust brokers while 53% state that they do not have money available to invest. For 90% of U.S. households, a market shift of 10%, which is enough to signal a market correction, their wealth holdings would only have an impact of 1% to 2%.

What type of investor is a contrarian?

Investors who tend to be contrarian in their investment choices tend to thoroughly research the companies and their fundamentals. The companies that are chosen tend to have solid reputations and stable profit margins.

Contrarian investing does not follow a bull market or bear market view. They believe that the value of an investment is below its intrinsic value. As such, they view the investment as presenting an opportunity to make a profit. Instead of investing only during bull markets, these types of investors invest whenever a stock is undervalued.

Contrarian methods

There are several methods that are used for contrarian investing. These investors typically have strong research skills and choose companies that are heavily financed, are undervalued for the wrong reasons, and that have good profit margins.

The price to earnings ratio is factored in, but the P/E ratio is not the only thing that is considered. You should look for stocks that have a low price to earnings ratio or P/E ratio.

The price to earnings ratio or P/E ratio measures a stock’s current price compared to its earnings per share. The P/E ratio is determined by multiplying the share price by the number of fully diluted shares that are outstanding. Then, you divide the product by the sum of what the company has earned over the past four quarters to determine the price to earnings ratio of the stock.

You should identify when movements are exaggerated, which is when they extend past a sensible point. The market tends to focus on the short-term because of overreaction that causes an exaggeration in the amounts of price increases and decreases. This allows knowledgeable investors to profit.

Contrarian investing involves buying when others are selling and selling when others are buying. Contrarians typically purchase low-valued securities called dogs and sell hot securities that other people want. They do not pay attention to whether the market is a bear or bull market.

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A recession can offer a great opportunity to invest if you are an adept investor who is able to hold a long position and who is able to spot behavioral market trends. If you identify a stock that is undervalued but that you expect to boom in the future, you can invest in it. This is called trend investing and involves buying a stock before it trends upward and then riding the trend up before you sell.

The major factor is determining which stocks to buy and sell after the stocks recover. The key is taking a long-term view of your investments. This helps to minimize the impact of the volatility that is caused by short-term market swings.

How to think like a contrarian

To think like a contrarian, you can do several things. To figure out high volatility periods, look at indices such as the Chicago Board Options Exchange Volatility Index or VIX. Figuring out periods of high volatility that result from the emotional exaggeration of market participants can open up favorable buying opportunities.

Identify high trading volumes, which indicate investor interest and a possibility that a stock is overvalued. Instead of investing in these types of high-volume stocks, look for stocks that are undervalued. Another potential indicator of mispricing of a stock is a high level of investor interest.

Some indicators that you should look for in stocks when contrarian investing include the following:

  • Low price to earnings ratio
  • Low price to cash flow
  • Low price to book
  • Low price to dividend

The bottom 20% of the market is the focus. Other factors that you should consider include the following:

  • Low payout ratios
  • High return on equity
  • Higher than average dividend yield
  • Pre-tax profit margins of a minimum of 8%

Purchase stocks that are rated as a sell, and hold onto them until their prices improve. When their prices improve, sell them then. Sell stocks that have been downgraded by analysts. Since these stocks are usually behind the trends of the market, look for expert opinions on the stocks before including them in your list.

Look for short-selling. This occurs when borrowed shares are immediately sold with the intention of purchasing them at a lower price to return them to the lender and profit off of the difference. The short-interest ratio should be used in this analysis. Normally, stocks have a rating of five or less. This means that you should aim for ratios of six or higher. This is a method that is typically only used by savvy investors.

Look for large institution interest in which the ownership is more than 65%. The absolute minimum is 50% ownership. The idea behind this is to have institutional investors driving up the price.

Finally, you must be ahead of the financial news. Once it hits, your opportunity may already have passed.

Value investing vs contrarian investing

There are some similarities between contrarian investing and value investing. Warren Buffet engages in value investing, which is an investment strategy in which the stocks that are chosen appear to be trading for less than their intrinsic values.

When investors follow the value investing theory, they try to identify undervalued stocks and then purchase them. To be a value investor, look for the following in stocks:

  • Below average price-to-book ratios
  • Lower than average price to earnings or P/E ratios
  • Higher than average dividend yields

The approach that Warren Buffet uses is that the market tends to overreact to financial news. This causes the stock price movements in the short term to not be related to a company’s fundamentals in the long-term.

Both strategies look for undervalued securities based on the investors’ reading of the current market trends. Both types of investors look for stock share prices that are lower than the intrinsic value of the company.

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The Dogs of the Dow

The phrase “dogs of the Dow” originated in 1991 in Michael B. O’Higgin’s book, “Beating the Dow.” It is a value investing strategy that was created to perform as closely as possible to the Dow. It is a long-term, conservative dividend strategy that encourages you to invest in the 10 highest dividend-yielding, blue-chip stocks that are listed in the Dow Jones Industrial Average each year.

The Dow Jones Industrial Average or DJIA is an index that tracks 30 large, publicly-owned companies trading on the New York Stock Exchange or NYSE and the NASDAQ. The DJIA was created in 1896 by Charles Dow and Edward Jones.

High yield dividend stocks are stocks that pay relatively high dividends and that have relatively low stock prices. Blue-chip companies are those that have market valuations of $10 billion or more. These companies also have solid growth histories and future potentials, are listed in major market indexes, and typically pay out dividends.

The dogs of the DOW strategy has outperformed the markets for the past four years and for seven out of the last 10 years. To implement this strategy, look at the DJIA on the last day of the year and choose the 10 high yield dividend stocks that are the highest. In the new year, invest the same dollar amount in each of the stocks on the first trading day of the year. Keep your original portfolio for the year. At the beginning of each subsequent year, repeat the process.

Investors add this type of contrarian mindset into their diversified portfolios because they hope to have a growing return that adds value over the long term.

Contrarian investing is an investment strategy that might help you to build your wealth faster if you are a savvy investor. M1 Finance may help you to build wealth even if you are new to investing and are relatively unfamiliar with this investment strategy.

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