Contrarian investing

This post is about contrarian investing both past and present and how to successfully apply it to whatever market you invest your capital. To understand contrarian investing you need to understand the origins of the philosophical idea. Understanding original thought is always the most useful information.  Therefore, his post is to:

• describe the origins of contrarian thinking
• what is modern contrarian investment strategies entails and how it departs from original economic thought
• how you can make money in the stock market with this strategy

Pareto’s contrarian thinking

The idea to go against the trend is nothing new. However, in modern economic thinking, the idea arose from the Italian economist Vilfredo Pareto. In 1906 be wrote how 80% of the land belonged to 20% of the population. He went on to see the 80/20 ratio in many other things. For example, he noted that in his garden 20% of the pea pods produced 80% of the output. He also wrote how to aggregate wealth distribution also followed this pattern.

The natural investment conclusion was if you followed 80% of the people you would be in the group with 20% of the wealth. While if you went against the trend you would be in the group controlling 80% of the capital. Pareto did not directly write this but this is how contrarian extrapolated this to an investment strategy.

Modern contrarian investing

Economist Paul Krugman rebutted Pareto with economic data that suggest that 20% of the wealth was now controlled by 1% of the population.  However, the idea still sounds, that if you do what everyone else is doing it will not get you anywhere.

In fact, when I was working at Merrill Lynch as a stockbroker I saw observed some things which seemed to support the theory of contrarian investing. Here are a few examples.

• There was a study that looked at the news headlines for over fifty years. In almost every case when people were expecting a downturn as described by the news, the stock market rallied. The converse was also true. This loosely supports contrarian thinking.
• If you look at odd-lot investors, which often is a technical indicator of the common man investor, is usually is a conta-indicator for the stock market.
• My personal observation of the investing population is people are emotional and tend to buy high when ta stock is rallying and sell low when it is falling. This is the opposite of what you want to do. This is an investing proverb that does ‘buy on bad news and sell on good’.

I purposely wanted to stay general with this post and not look at statistical studies that support or disprove the contrarian. Why? Because statistics and studies can be misleading depending on the variables you choose to look at. Therefore, I prefer to simply discuss this in the abstract.

How to make money with contrarian investing

The worst way to invest is simply to try to get rich quick by investing in a stock that is falling or in the dumps. Do not be a junk man looking for scraps in the junk pile. This is not contrarian investing. Contrarian investing in my mind is another word for value investing. That is looking for stocks that have lost favor, however, the company continues to make money. Or if the economy is stable and strong, to all of a sudden bet on a crash. This is trying to guess the business cycle not investing.

The second worst thing to do as an investor is to follow the crowd behavior.  This using behavioral finance to make above-normal profits. Many people love to invest in the ‘hot stock of the month’. This is money and capital flow to equities that have hype around them. They have a story which someone has built up. My advice is to ignore the news. I told this to an expert working at Bloomberg, the financial information company and he looked at me in a strange way. However, what makes news and what does is not always what will make money for you. Expectation is so quickly built into the price of an asset that it is very hard for an outsider to get any news that will positively have an impact on your rate of returns or your portfolio. In fact, the converse is true and this is where contrarian investing works.

• buy stocks that have strong fundamentals as manifest by low debt and strong cash flow and profit margins, however, have no flash or story or notoriety. If it is in the news and people are talking about it then you have already lost.
• use any number of stock screeners, professional or free to refine your determinate criteria for finding value. Some people like high dividend payout, low P/E or dogs of the Dow. I do not look at these, maybe P/E. Develop your own methods of stock screening. The aim is not to find a stock but to lower the number of stocks you need to look at to a manageable level.
• remember all investing comes down to the management team. Look at the team you want to invest in, do the research, have they done well in the past?
• be a contrarian, find something that you feel does not add up. To find something that were subjective price forces of supply and demand depart from something called natural value.  For example, I was investing in oil stocks that were out of favor when I just felt it did not make sense that these stocks were so low.  When the Polish currency was too strong against the dollar, it did not make sense. I did not look at statistical data or read the headlines. I just felt people got too caught up in the hype. Look around you and decide what does not make sense to you based on your observations. This is contrarian investing.

If you are a contrarian investor you can make money in a bull or bear market, by playing the market either with longs and shorts or put and calls. You can always make money in the stock market.