Contrarian investing
Encyclopedia
In finance, a contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom
, when the consensus opinion appears to be wrong.
A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism
about a stock
can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism
can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don't pan out. Avoiding (or short-selling) investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether the investment in question is an individual stock, an industry sector, or an entire market or any other asset class.
Some contrarians have a permanent bear market view, while the majority of investors bet on the market going up. However, a contrarian does not necessarily have a negative view of the overall stock market, nor does he have to believe that it is always overvalued, or that the conventional wisdom is always wrong. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced. While more "buy" candidates are likely to be identified during market declines (and vice versa), these opportunities can occur during periods when the overall market is generally rising or falling.
in that the contrarian is also looking for mispriced investments and buying those that appear to be undervalued by the market. Some well-known value investors such as John Neff
have questioned whether there is a such thing as a "contrarian", seeing it as essentially synonymous with value investing. One possible distinction is that a value stock, in finance theory, can be identified by financial metrics such as the book value
or P/E ratio
. A contrarian investor may look at those metrics, but is also interested in measures of "sentiment" regarding the stock among other investors, such as sell-side analyst coverage and earnings forecasts, trading volume, and media commentary about the company and its business prospects.
In the example of a stock that has dropped because of excessive pessimism, one can see similarities to the "margin of safety" that value investor Benjamin Graham
sought when purchasing stocks—essentially, being able to buy shares at a discount to their intrinsic value
. Arguably, that margin of safety is more likely to exist when a stock has fallen a great deal, and that type of drop is usually accompanied by negative news and general pessimism.
Along with this, although more dangerous, is shorting overvalued stocks. This requires 'deep pockets' in that an overvalued security may continue to rise, due to over-optimism, for quite some time. Eventually, the short-seller believes, the stock will 'crash and burn'.
Indexes (informally also referred to as "Fear indexes"), like VIX
, which by tracking the prices of financial options
, gives a numeric measure of how pessimistic or optimistic market actors at large are. A low number in this index indicates a prevailing optimistic or confident investor outlook for the future, while a high number indicates a pessimistic outlook. By comparing the VIX to the major stock-indexes over longer periods of time, it is evident that peaks in this index generally present good buying opportunities.
Another example of a simple contrarian strategy is Dogs of the Dow. When purchasing the stocks in the Dow Jones Industrial Average
that have the highest relative dividend yield
, an investor is often buying many of the "distressed" companies among those 30 stocks. These "Dogs" have high yields not because dividends were raised, but rather because their share prices fell. The company is experiencing difficulties, or simply is at a low point in their business cycle
. By repeatedly buying such stocks, and selling them when they no longer meet the criteria, the "Dogs" investor is systematically buying the least-loved of the Dow 30, and selling them when they become loved again.
When the Dot com bubble started to deflate, an investor would have profited by avoiding the technology stocks that were the subject of most investors' attention. Asset classes such as value stocks and real estate investment trust
s were largely ignored by the financial press at the time, despite their historically low valuations, and many mutual funds in those categories lost assets. These investments experienced strong gains amidst the large drops in the overall US stock market when the bubble unwound.
, and there is significant overlap between these fields. For example, studies in behavioral finance have demonstrated that investors as a group tend to overweight recent trends when predicting the future; a poorly-performing stock will remain bad, and a strong performer will remain strong. This lends credence to the contrarian's belief that investments may drop "too low" during periods of negative news, due to incorrect assumptions by other investors, regarding the long-term prospects for the company.
Conventional wisdom
Conventional wisdom is a term used to describe ideas or explanations that are generally accepted as true by the public or by experts in a field. Such ideas or explanations, though widely held, are unexamined. Unqualified societal discourse preserves the status quo. It codifies existing social...
, when the consensus opinion appears to be wrong.
A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism
Pessimism
Pessimism, from the Latin word pessimus , is a state of mind in which one perceives life negatively. Value judgments may vary dramatically between individuals, even when judgments of fact are undisputed. The most common example of this phenomenon is the "Is the glass half empty or half full?"...
about a stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism
Optimism
The Oxford English Dictionary defines optimism as having "hopefulness and confidence about the future or successful outcome of something; a tendency to take a favourable or hopeful view." The word is originally derived from the Latin optimum, meaning "best." Being optimistic, in the typical sense...
can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don't pan out. Avoiding (or short-selling) investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether the investment in question is an individual stock, an industry sector, or an entire market or any other asset class.
Some contrarians have a permanent bear market view, while the majority of investors bet on the market going up. However, a contrarian does not necessarily have a negative view of the overall stock market, nor does he have to believe that it is always overvalued, or that the conventional wisdom is always wrong. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced. While more "buy" candidates are likely to be identified during market declines (and vice versa), these opportunities can occur during periods when the overall market is generally rising or falling.
Similarity to value investing
Contrarian investing is related to value investingValue investing
Value investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
in that the contrarian is also looking for mispriced investments and buying those that appear to be undervalued by the market. Some well-known value investors such as John Neff
John Neff
John Neff is one of the best known mutual fund investors of the past 40 years, notable for his contrarian and value investing styles as well as heading Vanguard's Windsor Fund. Windsor was the best performing mutual fund during his tenure and became the largest fund closing to new investors in the...
have questioned whether there is a such thing as a "contrarian", seeing it as essentially synonymous with value investing. One possible distinction is that a value stock, in finance theory, can be identified by financial metrics such as the book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
or P/E ratio
P/E ratio
The P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
. A contrarian investor may look at those metrics, but is also interested in measures of "sentiment" regarding the stock among other investors, such as sell-side analyst coverage and earnings forecasts, trading volume, and media commentary about the company and its business prospects.
In the example of a stock that has dropped because of excessive pessimism, one can see similarities to the "margin of safety" that value investor Benjamin Graham
Benjamin Graham
Benjamin Graham was an American economist and professional investor. Graham is considered the first proponent of value investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book...
sought when purchasing stocks—essentially, being able to buy shares at a discount to their intrinsic value
Intrinsic value (finance)
In finance, intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value...
. Arguably, that margin of safety is more likely to exist when a stock has fallen a great deal, and that type of drop is usually accompanied by negative news and general pessimism.
Along with this, although more dangerous, is shorting overvalued stocks. This requires 'deep pockets' in that an overvalued security may continue to rise, due to over-optimism, for quite some time. Eventually, the short-seller believes, the stock will 'crash and burn'.
Notable contrarian investors
- Warren BuffettWarren BuffettWarren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
is a famous contrarian, who believes that best time to invest in a stock is when shortsightedness of the market has beaten down the price. - David DremanDavid DremanDavid Dreman is a noted investor, who founded and is Chairman of Dreman Value Management, an investment company. The company focuses on the assets of mutual funds, pension, foundation, and endowment funds, as well as high net-worth individuals....
is a money manager often associated with contrarian investing. He has authored several books on the topic and writes the "Contrarian" column in Forbes magazine. - John Neff, who managed the Vanguard Windsor fund for many years, is also considered a contrarian, though he has described himself as a value investor (and questioned the distinction).
- Mark RippleMark RippleMark E. Ripple, born August 30, 1967 is an American money manager, ,. and author of . He is frequently sought after to pen articles, having written for American Turf Monthly, The Horse Jockey, CBS, and . He’s been featured in American Turf Monthly and Motley Fool, and has been a featured financial...
is a money manager often described as a contrarian. He has authored a book covering the topic in detail. - Anthony Gallea is a portfolio managerPortfolio managerA portfolio manager is either a person who makes investment decisions using money other people have placed under his or her control or a person who manages a financial institution's asset and liability portfolios....
and founder of The Pelican Bay Group at Morgan Stanley Smith Barney. He and his colleagues oversee the investment management of $1 billion for individual and institutional clients as of January, 2011. Gallea is the co-author of Contrarian Investing, published in 1998 by New York Institute of FinanceNew York Institute of FinanceThe New York Institute of Finance has its headquarters in Midtown Manhattan, New York City.-History:The earliest record available about what came to be known as the New York Institute of Finance is the introduction to a book called “Stock Exchange Procedure” by Birl E. Shultz, PhD. In 1936 he was...
. - Rob Still is a sales manager at Alexander Hall who invested in Barclays.
Examples of contrarian investing
Commonly used contrarian indicators for investor sentiment are VolatilityVolatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
Indexes (informally also referred to as "Fear indexes"), like VIX
VIX
VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over...
, which by tracking the prices of financial options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, gives a numeric measure of how pessimistic or optimistic market actors at large are. A low number in this index indicates a prevailing optimistic or confident investor outlook for the future, while a high number indicates a pessimistic outlook. By comparing the VIX to the major stock-indexes over longer periods of time, it is evident that peaks in this index generally present good buying opportunities.
Another example of a simple contrarian strategy is Dogs of the Dow. When purchasing the stocks in the Dow Jones Industrial Average
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...
that have the highest relative dividend yield
Dividend yield
The dividend yield or the dividend-price ratio on a company stock is the company's total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage...
, an investor is often buying many of the "distressed" companies among those 30 stocks. These "Dogs" have high yields not because dividends were raised, but rather because their share prices fell. The company is experiencing difficulties, or simply is at a low point in their business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
. By repeatedly buying such stocks, and selling them when they no longer meet the criteria, the "Dogs" investor is systematically buying the least-loved of the Dow 30, and selling them when they become loved again.
When the Dot com bubble started to deflate, an investor would have profited by avoiding the technology stocks that were the subject of most investors' attention. Asset classes such as value stocks and real estate investment trust
Real estate investment trust
A real estate investment trust or REIT is a tax designation for a corporate entity investing in real estate. The purpose of this designation is to reduce or eliminate corporate tax. In return, REITs are required to distribute 90% of their taxable income into the hands of investors...
s were largely ignored by the financial press at the time, despite their historically low valuations, and many mutual funds in those categories lost assets. These investments experienced strong gains amidst the large drops in the overall US stock market when the bubble unwound.
Relationship to behavioral finance
Contrarians are attempting to exploit some of the principles of behavioral financeBehavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
, and there is significant overlap between these fields. For example, studies in behavioral finance have demonstrated that investors as a group tend to overweight recent trends when predicting the future; a poorly-performing stock will remain bad, and a strong performer will remain strong. This lends credence to the contrarian's belief that investments may drop "too low" during periods of negative news, due to incorrect assumptions by other investors, regarding the long-term prospects for the company.
See also
- Value investingValue investingValue investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
- Dow Jones IndexesDow Jones IndexesDow Jones Indexes was formed in 1997 as an entity within Dow Jones & Co. It is now owned by the CME Group. It serves as the marketing name of CME Group Indexes, LLC. It produces, maintains, licenses and markets indexes as benchmarks and as the basis of investible products such as exchange traded...
It has a section on the Dow Jones Contrarian Indexes.