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How to swim against the tide and WIN in stock markets

Last updated on: October 12, 2012 10:25 IST

How to swim against the tide and WIN in stock markets

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Morningstar.in

A great many investors in financial history have been contrarians. Here are skills contrarian investors need to possess.

There are various approaches to stock investing. You could invest in an index fund and pocket the market's return or be an active stock picker to try and beat the market, be a buy-and-hold investor or one who actively churns stocks and sectors frequently.

But one distinct trait that many of the world's greatest investors share is one of being a contrarian, or investing against the market's grain. Of course, you could combine the contrarian approach with any of the above-mentioned approaches (with the exception of buy-and-hold) to produce great investing results.

So what does a contrarian investor do? Here's a look.

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Be a contrarian

Perhaps the most eloquent statement ever made to describe the power of being a contrarian was Warren Buffet's now-legendary 'be fearful when others are greedy and greedy when others are fearful' advice he gave to Berkshire Hathaway shareholders in his annual 2004 letter.

Behavioural-finance studies suggest investors often rush into stocks near peaks when euphoria is maximum and cash out near market bottoms.

On the other hand, a contrarian investor typically bets big when stocks or overall markets are depressed and when pessimism is high and may start lightening up on stocks when valuations start looking over-stretched due to lack of opportunities.


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Ascertain value

Which brings us to the point: how does the contrarian investor tell when stocks are looking under or over valued? Further, how does s/he discern whether a stock is offering true value or is a value trap (stocks that appear cheap on a valuation basis continuing to remain cheap).

Anyone who bought real estate and infrastructure stocks after the 2008 crash -- after stocks had corrected between 50 per cent and 80 per cent from the top -- knows that just because a stock has started looking undervalued on traditional valuation metrics such as price-to-earnings or price-to-book does not always mean you are in for market-beating returns.

Conversely, you could have bought in early on the past decade's multibaggers like Titan or VIP Industries and sold early after an initial run -- thinking it to be a contrarian play -- even as they went on to multiply several times.

What should matter to a contrarian investor is the underlying fundamental of the business and whether it looks mis-priced at the current price level with respect to its intrinsic value, irrespective of the price move it has witnessed.

Use Morningstar's fair value estimate for stocks and the accompanying analysis our equity analysts put out to know our view on a stock. We also provide 'Consider Buy' and 'Consider Sell' levels for each stock we cover -- levels we think offer a reasonable margin of safety to buy or where valuations look stretched, respectively -- and a keen contrarian investor would be interested in knowing about these.


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Have conviction

Since it is virtually impossible for any investor to consistently time the market, a contrarian investor could often find himself under performing the market or making a move that may backfire in the short term.

Remember in a bear market, a stock that has corrected a lot can go on to correct a lot more, and a contrarian investor should enter a stock once he is sure of the stock's mis-pricing with respect to its fundamentals, even if it means the stock continues to undergo more short-term correction.

If you keep on waiting hoping to catch a stock right at its bottom, you might miss a swift bounce-back that is often associated with fundamentally-sound, beaten-out-of-whack stocks. (Remember the rally between March and August 2009 when stocks doubled in about six months and several investors were caught holding cash?)


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Know your risk appetite

While it may be tempting to go all-in when you sense a contrarian opportunity, it will always be prudent for any investor to know how much she can afford to lose in a worst-case scenario, should her/his assumptions about an investment decision don't turn out as expected.

A contrarian investor, however, tends to better understand her/his risk profile compared to a go-with-the-herd investor as the latter often under/overestimates her/his risk appetite by becoming -- like the consensus -- overtly optimistic (and thereby a bigger risk-taker) during a bull run and pessimistic (and risk-averse) in a downturn.

If you are not sure how much risk you can take (remember even a temporary downswing could test your conviction, cloud your thinking and lead you to take irrational decisions), make sure you have diversified your holdings across stocks/sectors as opposed to investing in a handful to minimise correlation.


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