This Article was originally published in The Global Analyst
The world’s best contrarian investor is none other than Warren Buffet. A contrarian investor will be greedy when others are fearful and vice-versa. It simply means going against the grain and prevailing wisdom and doing things contrary to what others are doing. While, as a concept, it may appear simple, it is difficult to go against the grain in real life. Buying a stock and when others are selling requires a different investing approach and involves behavioral biases. Though the concept aligns mostly with value investing, there are subtle differences between the two. Value investing almost always involves buying stocks “cheap” while contrarian investing sometimes can buy stocks even when it is not cheap. A classic global example would be Volkswagen which sold off 46% in 2015 (from Euro 250 in March 2015 to Euro 109 in October 2015 before recovering to Euro 180 by January 2018) based on a news that it was untruthful about emission tests in US. A contrarian investor would have ignored the negative hype and instead would have bought it given the brand strength of such a stock. But that would have involved swimming against all the negative news surrounding the stock. While traditional portfolio management involves a top down approach, where one checks the economy and industry before committing to a stock, a contrarian investor is a bottom-up person that ignores the broader macro environment and even the industry setting and instead focuses on the stock to the exclusion of its economic and sector environment.
If one has to pursue this investment style, there are some required traits. Most importantly it includes patience, discipline, conviction and communication. The opportunities for a contrarian investors can be rare and hence patience is a virtue here. Efficient market hypothesis says that all the news is always priced into a stock instantly. In that case, finding that stock where it has been wrongly evaluated by the market should be a rare vent. The investment style requires a much disciplined approach to identity opportunities and once an opportunity is identified, one needs enormous conviction to bet against the market. If one is managing money for an institution, then effective communication on why he/she bought those stocks is key to keep investors glued to the strategy.
The contrarian style is not without its pitfalls. If one is managing a mutual fund, then such a strategy induces sizeable tracking error relative to benchmark. Tracking error measures the deviation from te benchmark. Most of the bets contrarian managers take may not have sizeable weightage in the index thereby contributing to the tracking error. Many institutional investors have tracking error thresholds after which they will have to redeem their investments. Hence, this strategy may not be suitable for all types of investors. Another problem will be timing the investment. Contrarian investors generally revel on bad news to accumulate their holdings. However, the fall in a stock price can be long and deep in which case buying them early can induce losses that needs to be covered later. When to buy, even when there is a bad news, is a tricky question. In most of the situation, the manager may be hard pressed to explain the rationale of explaining his investing decisions as it clearly shows that he is doing something out of ordinary. Many stock price falls, invariably has a known as well as unknown reason. As they say, a stock is “cheap for a reason”. If not researched properly to uncover the unknown reason behind a stock fall, a contrarian investor would end up holding a dud stock.
Be forecast-averse
The biggest hurdle of being a contrarian investor is to go against forecasters, both economic and stock. The contrarian investor can ignore economic forecasts as the investing approach is more bottom-ups. But still in a recession driven economic scenario like the present one where stocks are widely expected to perform poorly, holding a contrarian portfolio will definitely raise more questions than answers. However, the main problem would be equity research forecast that may paint a negative picture which the contrarian investor need to overlook and go against. In short, a contrarian investor must be “forecast averse” in order develop his conviction on the style.
Where it works
The concept of contrarian investing is normally understood better in the context of buying a deeply undervalued stock (on the back of some verified/unverified information) much against street advice. However, the style works equally well for taking sell decisions as well. This is particularly true when the stock has run up beyond expectations and is no longer justifying its fundamental value. In this case, the manager is better off selling. It will also be a good idea to sell when there is over optimism behind a stock as the stock will enjoy adequate liquidity and buying interest and hence realizing a good price is quite possible.
While the contrarian style is intuitively appealing, as said before it should not be an all-encompassing strategy for an investor. While the core part of an investor portfolio should be the time-tested long-only portfolio, styles like contrarian can at best be a satellite component to generate additional sources of alpha. There can be other satellite approaches like momentum, disruption as a theme, etc. With such a structure, the risk of a particular strategy pulling away the main source of return is fairly diminished.
A contrarian investment style is clearly suited only for sophisticated investors (institutional and high net worth) who can appreciate the risk inherent in the strategy. Embracing a contrarian style involves trusting manager’s judgement in such calls and that requires a clear understanding of what the risks involved are. It is certainly not for the faint-hearted individual investors whose risk appetite may not suit such a strategy.