Why Contrarian Investing Works
Eric J. Marshall, CFA, Hodges Capital Management, North Dallas LIVING WELL Magazine (formerly SENIOR Magazine)
Over the long run contrarian investing is effective because it combines fundamental securities analysis with a common sense understanding of behavioral finance. Three basic benefits that can be derived from such an investment strategy:
1. A contrarian approach can help to neutralize certain emotional elements in decision making.
2. Contrarian investing can aid in limiting relative downside risk.
3. A contrarian strategy may also represent the best chance for investors to indentify mispriced securities.
The majority of investors know that they should buy low and sell high, but most struggle to overcome the prevailing tide of popular opinion when investing in stocks. Instead, we are drawn to buy what everyone else is buying and sell what everyone else is selling. The human brain is naturally wired to go along with the majority. Although the concept that there is safety in numbers may be true in nature, it does not lend itself to buying low and selling high.
Helping to overcome the emotional aspects in decision making, a contrarian approach to investing can uncover irrational valuations in the market that are the result of basic human behavior. As long as humans are involved in the decision making associated with buying and selling securities, capital markets will not always function in a rational manner. This is due to the fact that human beings are not always rational decision makers, especially when they are acting as a large group. While using a disciplined contrarian approach cannot change this fact, we can benefit from having a basic awareness of the rationale behind the consensus opinions and market trends.
We are not suggesting that investors should continuously bet against the relative direction of the market trend; rather they instead independently formulate an investment thesis by questioning the prevailing popular opinions surrounding a stock or investment theme. An investment thesis that is contrary to the consensus view must be supported by facts, facts, and more facts, as well as a detailed argument that differentiates the contrarian view from the mainstream opinion. Most importantly, a contrarian investment thesis must have an upcoming catalyst or catalysts to overturn the tide of investor sentiment and result in an increase in incremental buying in a given security.
An important element to contrarian investing is the potential to limit risk on a relative basis. Perceived risks associated with stocks that have been beaten down and left for dead are often greater than reality. One reason this may occur is that the trading prices of stocks that have lost considerable value tend to capitulate, in which everyone who wishes to sell based on the bad news or a negative situation surrounding a security has already liquidated their investment. As a result, selling becomes exhausted and the trading action in a stock simply finds a bottom.
The idea that investors can generate excess returns relative to underlying risks requires the ability to identify inefficiencies in the market’s pricing of securities. If you buy into the multitude of academic arguments that suggest the stock market is always efficient and that market pricing is always rational, there is no use in active portfolio management or individual stock selection. However, we do not buy into the theory that markets are efficient and view the day-to-day volatility in stock prices as sufficient evidence that markets are not always fair in pricing individual stocks. In addition, out-of-favor stocks tend to be less followed by Wall Street analysts and investors at large and, therefore, tend to represent the greatest opportunity to uncover market mispricing. Once a stock or segment of the market has been widely sold off by investors and abandoned by institutional research departments based on a series of negative developments or lackluster expectations, it is especially worthwhile for a contrarian-minded investor to undergo research analysis on a prospective investment. It is under such circumstances that competition among investors for information is the lowest and therefore proprietary research efforts are likely to be rewarded.
The above discussion is based on the opinions of Eric Marshall and is subject to change. It is not intended to be a forecast of future events, a guarantee of future results and should not be considered a recommendation to buy or sell any security. Hodges Capital Management does not guarantee the accuracy or completeness of this commentary, nor does Hodges Capital Management assume any liability for any loss that may result from the reliance by any person upon any information or opinions herein. The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. You cannot invest directly in an index.