7 Key Things You Should Know on Contrarian Investing Strategy – Stock and Ladder (2024)

In the plains of the African national parks an event gets played out on a daily basis. The moment an impala or a deer senses danger and starts running; the rest of the herd also joins the run. Many in the herd will not even know what triggered the running. Similar scenes can be observed in the plains of our stock markets too.
In times of euphoria like now, many investors are extremely eager to join the party by buying stocks of even unheard off companies. The moment any event that causes panic sets in, many investors wish to run away from the party in droves, even selling their core portfolio.
Doing the exact opposite of what the crowd is doing is what contrarian investing is mostly about and one which gives the investors a better chance of profit. What are the key things an investor should know about contrarian investing before he chases these large profits? Is this contrarian investing strategy an easy thing for a normal investor to practice?

1. Potential for huge profits

First things first. A large bet on a contrarian investment idea has the possibility to deliver windfall profits. It’s the equivalent of a jackpot or a royal flush in a poker game.
During the 2008 financial market crisis when the banking stocks were hammered, Warren Buffet made a 5 billion USD contrarian bet on Goldman Sachs and by 2013 (in 5 years) got a 62% return on his initial investment.Simply adapting this contrarian idea (when this information was publicly available) to the Indian market by investing in any of the well run private sector banks would have given similar handsome returns.
Setting aside the hindsight bias, let us look at the stock returns of HDFC Bank for the period OCT’ 2008 to Apr’ 2017.
Fig: HDFC Bank share Price for the period Oct 2008 till April 2017

Source: Morningstar
Excluding dividends, HDFC bank has risen 358%
Just like honey bees get attracted by the nectar in the flowers, investors get attracted by profits. If done properly, contrarian investing indeed has the potential to deliver huge profits
Having seen the potential rewards of this strategy, let us now see how we could apply contrarian investing

2. Four contrarian investing strategies

There are many possible ways to practice a contrarian investing strategy. In an excellent article on this topic, Professor Aswath Damodaran has listed four possible contrarian strategies one can adopt:
Biggest losersBuying into the biggest losers hoping that when the overreaction recedes, the stock will revert to the mean or normal levels.
Collateral Damage: This strategy is to look at situations where the market or a sector has turned negative, dragging the fundamentally sound stocks along with it
Comeback bet: This strategy involves analyzing the reasons for a drastic fall in price of a stock and taking positions in the security if you believe the reasons are temporary and fixable in nature.
“Long Odds” Option: This strategy involves analyzing the security (whose price has fallen for right reasons and there is no hope of a turnaround) to see if they have some proprietary technology, license, product which will increase the value of assets in the future.
Before we kid ourselves to do a buffet and search for own Goldman Sachs like contrarian investing bet, let us remind ourselves:
“Investing is simple but not easy” – Warren Buffet
This is equally true of contrarian investing also.

3. Don’t be contrarian for the sake of contrarian:

Adopting a contrarian approach blindly just for the sake of not following the herd can be an equally foolish thing to do. Michael Mauboussin articulated this point with a beautiful analogy in a presentation on contrarian investing:
If you’re in a movie theatre that catches on fire, you’d be best served to run out of the theatre in contrast to the contrarian tack to run into the theatre.
To drive home this point, let us look at another example from the 2008 financial crisis. Until the housing bubble burst, the stocks of realty companies were literally flying in the Indian stock market. The story is completely different after the crisis.
Fig: S & P BSE Realty Index for last 10 years (down 70%)

Source: Google finance
As is evident from the chart, the realty sector has not gone anywhere in the last 10 years post the 2008 crisis. The industry is plagued with excess debt, lack of transparency among many other things.
Any investor who wanted to be a contrarian for the sake of being contrarian ignoring the collective market wisdom and underlying financials would have endured lots of pain. (Obviously specific individual stocks would have given positive returns but you get the drift right?)

4. Patience to realize the full value

The market can stay irrational longer than you can stay solvent – John Maynard Keynes
The sheer momentum of the market forces may either drive the prices higher or lower before it takes a position in line with your contrarian idea. Many times the behavior of the market is akin to a huge cruise ship taking a U-turn where as you expect it to turn like a speed boat.
Your contrarian investing idea might be sound yet it is quite possible that it may take a very long time for the market to fall in line with your idea.
Eicher Motors ltd is a classic example of this. Check out the stock price movement for the last 15 years:
Fig: Eicher Motors share price from Jan 2002 to Jan 2017

Source: Morningstar
During early 2000, many thought Eicher motors was finished as the sales was floundering. The company was spectacularly revived and that turnaround is a story for another blog post. However, the point here is that even if you had taken a contrarian bet in early 2000, it would have taken few years for the idea to play out. Check out the share price table:
Fig: Share price of Eicher Motors at random intervals

Sometimes one needs to be prepared for the long wait for a contrarian idea to work without losing resolve, patience and sanity (as long as the original reason for investing remains valid).

5. Analysis of the investing rationale with double vigour

“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.” – Warren Buffett
When a contrarian strategy is adopted, you are going against the collective wisdom of thousands of individual participants and institutional investors who are also scrutinizing the same set of data and to hunt for the same market anomalies.
Even though it is a known fact that the market sometimes overreacts both ways, the prospect of finding a completely new and contrarian idea is extremely rare.
In case we do believe that we have found one such idea then the same needs to be analyzed even more rigorously than a normal investing idea.

6. Resist seeking social proof

Social proof is a powerful psychological concept which explains our behavior when we are unsure how to act during certain situations. There are many events which occur in the market for which we are unsure of the course of action to be taken. E.g. Brexit, Demonetization.
To know more about this uncertainty, if we switch on the television to hear the “expert” opinion, read newspapers, follow investing blogs or talk to friends then you may hear a point of view which is contrarian to what you are thinking.
Taking a contrarian approach would require you to resist the urge for social proof as your action will not resonate with the larger crowd .You may be lonely in your thinking and without any social comfort as you will seldom find anyone behaving similarly.

7. What it takes to be a successful contrarian

All the key considerations for successful contrarian investing have been beautifully summarized by Howard Marksin the July 2013 memo to his Oaktree clients:
To be a successful contrarian, you have to be able to:

• see what most people are doing,
• understand what’s wrong about most people’s behavior,
• possess a strong sense for intrinsic value, which most people ignore at the extremes,
• resist the psychological pressures that make most people err, and thus
• buy when most people are selling and sell when most people are buying.

Easy right?!

Final thoughts

Contrarian investing strategy is extremely rewarding with possibilities for large profits when you get it right. It is a particularly useful investing strategy during periods of bubbles and extreme market over-reaction.
However, as we have seen, adopting a contrarian approach requires very rigorous analysis of the idea, possibly a longer gestation period for the idea to fructify and also the resilience to psychological pressures like social proofing.
All this makes it a high risk strategy for the common investor.
For the impala or deer in the plains of Africa, safety is in the numbers. In the eventuality of an isolation from the herd their chances of survival becomes bleak. An investor however should not behave like an impala or a deer. For the investor, the ability to clearly identifying this herd mentality and deciding NOT to participate in this crowd frenzy, will be a significant investing achievement in itself.
Do you agree that contrarian investing is an inherently risky strategy for the common investor? Let me know in the comments.