Contrarian Investing: Concept, why it works and beware

Contrarian InvestingSometimes investing in the stock market through value investing It is not an easy task. Often times, we must have the ability to oppose the crowd if we think the crowd is wrong. This requires mental toughness, courage, and conviction. Therefore, it ends up paying off great results for investors. This is the basis of contrarian investing. In this article I will explain what contrarian investing consisted of, the reasons why it works and the precautions we must take when using this investment method.

What is this "contrarian investing"?

The “contrarian investing” investment method consists of investing in stocks or sectors penalized by the market when there are reasons to think that Mister Marketis wrong and the price of these assets does not correspond to their intrinsic value. Contrarian investing is, without a doubt, one of the most important branches of value investing.

Among its greatest exponents we can find investors such as David Dreman |, Peter Lynch or John Neff. However, all value investors have a contrarian approach to a greater or lesser extent. In fact, John Neff argues that being contrarian is nothing more than a quality of value investors.

Contrarian investing is not only about going against the market

Contrarian investing is not only about going against the market, but also about investing in companies or sectors forgotten by investors. As legendary investor Peter Lynch put it:

“The true contrarian is not the investor who takes the opposite side of a popular hot issue (i.e., shorting a stock that everyone else is buying). The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn”

That we can translate as:

“The real contrarian is not the investor who gets on the opposite side of a hot issue (for example, going short on a stock that everyone else is buying). The real contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn. "

Why does contrarian investing work?

As my admired said Benjamin Graham:

"The stock market in the short term is a voting machine, while in the long term it is a weighing machine"

In other words, the stock market in the short term is highly influenced by the psychology of the masses, while in the long term what determines the price of a share is its business results.

Among others, the characteristics of the bag that make the contrarian methods successful are the following:

  • La market myopia, which places more attention on the short term than the long term.
  • El herd effect
  • La market tendency to overreact to positive and negative news.

Precautions to take into account if we decide to invest against the mass

Many investors, especially beginners, tend to see contrarian opportunities everywhere that in reality they are not. The problem is that the market is often right when it leaves out a particular company or sector, and stocks fall for compelling reasons, not psychology-related issues. A good example was what happened with Spanish real estate companies after the burst of the bubble, when the market put each company in its place.

The essential factor to take into account is to determine if the company is undervalued for short-term reasons, from which the company may succeed in the medium term, or if otherwise we are facing structural problems that endanger profitability or even the existence of the company. In the first case, we may be faced with an opposing opportunity, while in the second it is advisable to stay away.