”Be fearful when others are greedy, and be greedy when others are fearful” – Warren Buffett
The above quote by Warren Buffett sums up contrarian investing in a nutshell, an approach to investing used by some of the most successful investors like Warren Buffett, John Templeton, and Peter Lynch, that has helped them make a fortune in the stock market. In this post, we are going to discuss:
- What is contrarian investing?
- How does contrarian investing work?
- What are the characteristics of a contrarian investor?
- Rules of being a contrarian investor
- Pitfalls of contrarian investing.
What is Contrarian Investing?
Contrarian investing is an approach where an investor bets against popular belief but only when the popular belief contradicts the rational thinking.
In other words, contrarian investing is about going against the market trends and focusing on the stocks and sectors that have immense growth potential in the long run, but are currently beaten down due to temporarily negative sentiment.
How does contrarian investing work?
To understand how contrarian investing works, you have to understand how markets behave. Benjamin Graham, father of value investing, said
“Market behaves like a voting machine in the short term, but a weighing machine in the long term”.
What it means is, in the short term, it is the sentiment and people’s opinion about the stock that drives the prices. If people think the stock will move up, because of some positive news or event, they will buy the stock pushing up the prices.
On the other hand, in the long term, it is the underlying fundamentals that determine how the stock is going to perform in the future. Companies with strong fundamentals have better potential to grow.
Since every share is a part ownership in a business, as the business grows in value,the part of the business owned by you, also grows proportionately.
Now, there are times when market (and its participants) behave irrationally, especially during extreme panic, when due to extreme pessimism, people start selling every stock.
While times like these are seen as bad time to enter the market, contrarian investors think rationally, see it as an opportunity, and look for beaten down stocks that have strong fundamentals and immense growth potential in the future, but are available at a bargain price.
When the negative sentiment dies down, and market return to its normalcy, contrarian investors, reap huge benefit of buying at a bargain, giving them multi-fold return in the future.
An example of such contrarian investing is the economic crisis of 2008, when global economic crisis pushed the global market into panic, leading to massive sell off across the globe. It was this time when the stocks with the best fundamentals were beaten down, trading at a huge discount.
While there were those who completely avoided investing in stocks, there were others that avoided the peer pressure and looked for quality stocks that were available at bargain, and enjoyed significant return in the subsequent years of growth and recovery.
But how can you become a contrarian investor? What are the things you need to become a successful contrarian? Let us dig deeper and understand what are the characteristics of a contrarian investor.
Characteristics of A Contrarian Investor:
There is a common saying ”you are what you think”, in other words, in order to become like someone, you have to think and inculcate their characteristics. Same can be said about contrarian investing. Every contrarian investor has some common characteristics, which are crucial for his success. These are:
They Un-follow the herd:
“Belief is perception of masses”, as humans are social animals, we suffer from what is called confirmation bias, which means that if a lot of people believe in the same thing, we assume it to be the right.
This may not always be true, just because lot of people believe in one thing, does not make it right, especially if it is against rational thinking. That is why, contrarian investing approach requires un-following the herd and developing an independent thinking, where investor looks at various facts, evaluates the situation without being emotionally biased, and makes his investment decisions based on his findings.
Contrarian investors do not care about the popularity of a belief system and have their own independent, rational thinking based on the facts that they come across, they are not afraid to have a different opinion, no matter how unpopular it may be.
So, the first rule of contrarian investing is to unfollow the herd if needed, and have an independent thinking, based on facts and research, no matter how unpopular it is.
As Warren Buffett once said “You are not right because people agree with you, you are right because you get your facts right”
Every disaster is an opportunity:
One of the things investors fear the most is a market crash, and there are valid reasons behind it.
It’s not a pretty picture watching your hard earned money being washed away right in front of your very eyes. What is a disaster for an average investor is an opportunity for a contrarian investor. How?
Contrarian investors always have eyes on stocks they like the most, all they have to do is wait for the time when they are available at a bargain.
A market crash is seen as a great opportunity by contrarian investors as it is the time when great stocks trade at a bargain price for them to buy. When the market returns to normalcy, contrarian investors stand to make windfall gains from such bargain buys.
Invest for Long Term:
No matter how good you are as a contrarian investor, there are certain rules of the market you cannot break. Stock market, by its very design, is meant to make money only if you are invested for long term. Stock you own will not go up just because you own them.
Think of it like a planting a seed, you cannot expect a seed to germinate the next day, give it some time to grow and it will deliver fruitful results.
Similarly, no matter how good your stock picking skills are, you cannot expect a stock to give you windfall gains in a short span of time.
The key is not just to be a contrarian, but also have a long term vision for your investment, and give them time to grow in order to provide meaningful gains.
Past performance does not guarantee future returns, economic conditions change all the time, many stocks that were seen as potential multibaggers once are nowhere to be found today.
That is why it is always important to stay vigilant and keep a track of any changes in the underlying changes in the stock. While a few bad quarterly results do not significantly affect the long term fundamentals, but if the company is showing continuous deterioration, it is always better to exit that stock and look for other opportunity.
Making frequent checks on underlying fundamentals and new developments in the business is important aspect of contrarian investing
Keeping an eye on the changing fundamental scenario will give you early signs of any adversity in the business, helping you in taking necessary actions and avoid any nasty surprises.
Rules of Successful Contrarian Investing:
Every game has some rules, which must be followed in order to succeed. Contrarian investing too has some basic rules, which every aspiring contrarian investor must follow. These are:
Look for Quality at a bargain:
Imagine this, you are being offered two shirts, one with perfect fabric, stitching, and fitting, but is priced at Rs, 5,000, the other one with poor quality of fabric and poorly stitched, priced at Rs.500. Which one would you like to buy? Of course the one priced at Rs.5,000 because even if its expensive, it has nice quality.
Unfortunately, one of the biggest mistakes most investors make is that when the market declines, they buy anything that looks cheap, without considering the quality of the stock and its future growth potential. Just because a stock looks cheap does not make it a good investment, unless it has some potential to grow in the future.
While looking at bargains, don’t just look at stocks that are trading at low P/E, it is also important to understand if they are backed by strong business, which can grow over the years, giving handsome returns to investors.
Do not panic:
Fear is one of the strongest emotion, and can dominate your rational thinking. Most investors lose money in the market not because they have picked a bad stock, but because they make their investment decisions on emotion rather than rational thinking.
When market decline, fear of losing money triggers us to sell every losing stock and bail out of the market to safety. But as Benjamin Graham said “While investing in stocks, a human can be his own worst enemy”
Don’t let panic and emotion make your investment decision, yes there will be times when a stock, despite strong fundamentals, will not perform well for sometime, but that does not make it a poor investment.
Remember it is not you or the stock that is at fault, it is the irrational behavior of people that leads to such panic. If you have a doubt on your investment decision, just revisit all the rationales based on which you made your investment decision and if that is largely unchanged, you do not have to worry.
Learn From Your Mistake:
There are two things you can do with your mistake, you can run from it, or you can learn from it.
One of the most important aspect of successful investing is learning from your mistakes, which allows you to get better, thus helping you make more rational decisions in the future.
Most people give up on investing the moment they suffer a loss, instead of giving up, try to retrospect and learn from the mistakes in the past and use it as a lesson for the future.
Pitfalls of Contrarian Investing:
There are always two sides of a coin. While contrarian investing could be very rewarding, it is not flawless, and has its own set of pitfalls that you must be aware and cautious about. What are those? Read on…
Hard To Practice:
While contrarian investing is rewarding, it is hard to practice. Going against the herd has never been easy, because while on one side you look like an idiot in the eyes of the masses, on the other side, there is always a self doubt whether you are doing the right thing.
Contrarian investing involves more of psychology than strategy, and can only be learned with experience over time. There will be mistakes and there will be losses, but over a period of time, you will start getting a hang of it and it will finally start paying off.
Does not guarantee success:
Despite all the evidences proving that contrarian investing works wonders, it does not guarantee success. Don’t get me wrong, this does not mean that contrarian investing does not work, what I mean is it is not a sure shot way to investing success. There are many examples where even the most successful investors have lost money in stocks.
For instance, in 1993, billionaire investor Warren Buffett invested in a shoe company called “dexter shoes” for $443 million, the company was making $40 million profit year on year, but soon ran into problems as the competition escalated, finally going out of business in 2008.
The example of Warren Buffett shows that despite careful analysis, and valuation, there is no guarantee of success. Future is always unpredictable, and no matter how impeccable your analysis is, there is always a level of uncertainty which you have no control over. The best way to tackle such failures is to take them as a learning lesson and be more careful next time.
Contrarian investing has been very successful approach to investing, but has been rarely practised by handful of investors.
What makes contrarian investing very interesting is that it takes advantage of adversity and has the ability to turn disaster into an opportunity.
Although it is difficult to go against the crowd, but if you are confident about your analysis, then by following contrarian investing approach, you can make a fortune for yourself.