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Contrarian approach to investing

Jun 13, 2007

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly and one by one" - Charles MackayMany a times companies become unpopular with investors for all sort of wrong reasons or reasons that are likely to reverse in near future. This provides an opportunity for contrarian investors to buy good stocks at cheap valuations and subsequently sell them at decent profits. In this article, we have made an attempt to explain this 'contrarian style' of investing and how investors could benefit from the same.

What is contrarian investing?
According to the 'Dogs of the Dow', Contrarian investing is a strategy adopted based on the premise that a market, sector, or stock is not going to move in the direction that is expected by the majority of market participants. This means that the negative sentiments surrounding the stock are transient in nature and hence provides an opportunity to buy stocks when they are trading cheap. In essence, contrarian investing is an investment style that goes against the consensus or prevailing market trends to buy stocks that are trading cheap and then selling when they perform well. However, it is easier said than done, as contrarian investing requires great courage and conviction.

Similarity to value investing
Contrarian investing is related to value investing in the sense that a contrarian investor is looking for mispriced investments i.e. buying stocks when they are undervalued. In essence, the investment style of a value investor is basically contrarian because he is buying a stock, which has been undervalued by markets for reasons that are short-term in nature.

Should one always be contrarian?
Contrarian is just one of the many investment strategies adopted by successful investors. Being a contrarian does not mean going against the crowd in all instances, but investing differently based on hard – researched facts. This is because markets are right most of the time, and an investment based on loose information will be nothing but foolhardy.

An example of contrarian investing…
To illustrate how investors can benefit from contrarian investing, we would like to take the case of Britannia Industries. Due to a sharp rise in wheat prices in mid - 2006, the operating margins of Britannia Industries were reduced to half. The poor financial performance was reflected in the company's stock price, which underperformed the broader markets for the next 10 months. This would have been an opportune time for a contrarian investor to buy the stock as the key reason for the negative sentiments – high wheat prices, was short-term in nature. No government could have afforded to let the wheat prices remain that high for too long. We were perhaps amongst the few firms that came out with a positive recommendation on the stock (click here to read the recommendation) It has gained nearly 35% since then.

Counterpoints to contrarian investing…
If contrarian thinking is so effective, you might think why doesn't everyone do it? In the first place, if everyone did it, then it would not work because there would be fewer panics and distress sales in the market and hence fewer opportunities for contrarian investments. Second, it can be very depressing for investors to be wrong and contrary at the same time, the embarrassment of going against the consensus when the consensus is right (which might happen) is devastating. And third, much of our education and socialization teaches us to believe in numbers i.e. crowd and hence it takes a lot of courage and conviction to be a contrarian investor. Hence, only a seasoned investor can benefit from the same.

To Conclude...
All in all, contrarian approach provides a good opportunity to benefit from the short-term mis-pricing of stocks. However, an investor needs to back his investments with hard-facts as markets are right in most of the cases.

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