How to use contrarian investing to boost returns
Contrarian investing is one of the hardest investment tactics to master. Buy low, they say, then sell high.
‘How low is low?’ you may wonder. Piled in too early, you could be catching a falling knife. Too late, you may have already missed out on a large portions of the gains. Worse still, some assets may look like a ‘bargain’ trading at 30p to the pound, But in reality, they are destined for the scrapheap.
A major branch of contrarian investing is value investing a la Benjamin Graham. Some called this the ‘cigar butt’ approach. “Though the stub might be ugly and soggy,” explains Warren Buffett in 2014, “the puff would be free. Once that momentary pleasure was enjoyed, however, no more could be expected.”
Below is a summary of how to generate contrarian ideas in the stock market.
Five Questions to Generate Contrarian Ideas
- Which sectors/stocks are out of favour right now? A simple performance comparison will tell you which markets/sectors/stocks are badly underperforming, and for how long.
- Market or individual negativity driving prices down? For example, Metro Bank, one of the most shorted UK stocks, is encountering huge capital problems. But Lloyds is not. So Metro’s problem is not sector-wide and its problems may even benefit other competitors.
- Temporary or permanent problem? If a sector is down, is it due to problems that are temporary or permanent? For example, the shift to online purchases is a permanent trend that is lowering the value physical stores. Hence investors are pricing in this fact into most retail owners, thus hitting many REITs. Let sector readjust first – before jumping in.
- Can the entity survive? Generate a worst-case scenario and test what will happen to that affected company/sector. Will the company survive? Even if it does, what will happen to its equity or debt?
- Any catalyst that could spark a turnaround? On a macro basis, the usual bullish catalysts are: Bailouts, QE, Monetary infusion, and fiscal policies. On a micro basis, turnaround catalysts are sector-dependent. For example, in oil & gas the predominant factor is energy prices; while the housebuilding sector are driving by house prices and credit.
It is obvious that contrarian investing is not for everyone. In fact, it is a risky proposition because you are taking a position against the crowd. Turning around a failing business requires lots of capital and patience. Even so, it may not survive long term. Take Thomas Cook, failing again for the second time in the five years.
Increase Your Chances at Contrarian Investing
Once you have a list of potential contrarian candidates, here are a few ways to improve the odds of success.
Diversify. Betting against the market opinion is not something you should do all the time. Financial markets are reasonable efficient at spotting failing businesses. Contrarian investing should only be conducted when the case is exceptionally strong. Even then, only risk a small percentage of assets per trade. Longevity is the key.
Stick to quality assets. Remember, during the ’08 GFC Warren Buffett did not buy every beaten-down asset in the market. He stuck to blue-chip firms that were hammered by the ongoing panic. Further, he did not move immediately into stocks. He used convertible preferred stocks (instruments that allowed him to buy stocks at certain price) to add further protection to his capital.
Bet on something that you know. Successful contrarian investing requires a few core things, one of which is ‘worth estimation’. This edge may come from balance sheet, product or market knowledge. Once you have this knowledge, you wait for the opportunity to buy out-of-favour assets at bargain prices.
Use proven indicators and patterns. Indicators like sentiment and momentum. At turning points, momentum usually leads trends. Watch for base breakouts – as this signals that the ‘accumulation phase’ is over.
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