Contrarian approach to investing works on the foundation of psychology of investors
Contrarian investing approach, as the phrase implies, is going against the herd. It advocates buying when most investors are selling in panic during market crashes or slowdown, and selling when there is euphoria or bull run in the market. It is also buying low PE (price-to-earnings ratio) stocks that are out of favour with investors and selling high PE newsmakers.
Contrarian approach to investing works on the foundation of psychology of investors, economic cycle of businesses, temporary events in any company or stocks, or any information that changes the fortunes of a stock in a moment.
How being contrarian helps
Warren Buffet, one of the greatest investors of all time, said, “Be fearful when others are greedy and be greedy when others are fearful.” This is the classic definition of contrarian investing in very precise language. Contrarian investing goes against popular consensus. Many top money makers in stock markets have been contrarian investors.
Let’s look at some of the approaches.
Buy when everyone sells: This is pretty common in a crash. A market crash takes down all stocks—even the stocks of companies that are pretty sound and growing above average growth rate in the market for years. A contrarian investor keeps an eye on such stocks. When the market crashes and everyone starts selling in panic, the contrarian investor will accumulate as many of these stocks as he can.
For example, when results of IT bellwethers like Infosys or TCS are below market expectations, many IT stocks fall. Yet, these are the very stocks contrarian investors wait to lap up when the market sells in panic or on impulse.
Sell when everyone buys: A simple way to identify when the market is about to peak is when investing in IPOs starts catching the fancy of investors and the buzz is about stock markets earning 100 per cent in a couple of months. During such phases, IPOs would start getting lined up one after the other for issue and each IPO would look like the next big thing in the stock market. Such events are indications that market has peaked and it may plunge anytime.
Buy low PE stocks because the company or sector is out of favour for investors: Many contrarian investors look for low PE stocks. PE ratio is a number that indicates the overvalued or undervalued nature of the stock’s price. A high PE ratio indicates that the investors have high expectations and are willing to pay a higher price for it. This pricing by the market may likely be higher than the intrinsic price of the stock.
Similarly, a low PE stock is one that has fallen out of favour with investors. The reason for low PE may be other factors that are unrelated to the financial performance of the company in question. A contrarian investor will invest in such stocks because the stock may see a multi-fold jump when investors show interest again.
When to take the contrarian route
Taking a contrarian approach requires due diligence, understanding the behaviour of the market, and huge amount of patience along with a little bit of luck. Contrarian approach requires your judgement to be based on hard cold numbers. For example, a company delivering 30% returns for the last couple of years will also be beaten by the market in general macro-economic event. This could be the right time to buy such stocks. Similarly, prolonged slowdown in commodity can be a good bet if you have idea about commodity cycle.
Important points for investors
First, contrarian approach does not automatically mean blindly going against the herd. It just means you are not swayed by the prevailing emotion in the market wherein investors start selling good stocks or buying overpriced ones. There are times when going against the crowd can actually be quite disastrous.
Second, contrarian approach requires huge dollops of patience. The bedrock of contrarian approach is to invest in underpriced stocks or stocks out of favour with investors and wait patiently for the prices to go up. The prices may go up the next day, or it may take 5 years. There is no option but to wait. The only thing a contrarian investor would be sure of in such cases is that the price would rise.
Finally, contrarian approach is not something that you adopt and reject as per your convenience. It is a long-term approach that you must take it if you intend to adopt this investing philosophy. Many investors who want to take this approach go against the crowd and buy a stock, only to lose their patience when the stock further goes down. Remember that identifying the exact peak and exact bottom of the market is impossible to time.
The prevalent contrarian thinking today
In India and the rest of the world, gold and oil have become hot assets in contrarian circles. Gold has seen prolonged slowdown for the last couple of years. Investors have lost interest in it and Governments (especially India, which has been one of largest consumers) have been discouraging its consumption. True to their nature, a few contrarian investors have been looking at gold as a possible investment vehicle.
Similarly, oil and the overall commodity market have seen low prices since the last few years. Oil is a commodity whose price is difficult to forecast due to its geopolitical significance and global triggers involved. However, it does not stop contrarian investors in putting their money where their mind is.
Illustration: Uttam Ghosh/Rediff.com
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