Contrarian Investing

The Ultimate Investor

Contrarian Investing (updated 27 Feb 99)

Confusion abounds about what contrary thinking is. Any mother would consider it an insult were someone to suggest that her baby was contrary. What mother wants to have a contrary child? In the investment world, the word generally has more complimentary connotations, though there is still little clarity on what it precisely means.

Many think that contrary means always going against the majority - that a contrarian investor is automatically acting in counterpoint to the current market trend. In a long bull market, this implies being like Cassandra, who made doleful predictions that were met with scorn, and while ultimately proved right, was never believed at the time. Similarly, on this view, contrarians bet against the common wisdom in the hope of making a killing.

Another angle contrasts the contrarian with the fundamental or value investor, who buys and sells on the basis of assets' prices relative to their 'intrinsic value' (see VALUE INVESTING). Instead, a contrarian trading strategy is based on the assumption of negative serial correlation of prices: a predictable pattern such that if prices have gone up, they must come down, and vice versa. This view of contrarians focuses on the important role of fads: rather than acting independently, investors exhibit herd-like behavior, following waves of mass optimism and pessimism (see INVESTOR PSYCHOLOGY).

To a third group, contrarian investing is the reverse, a steadfast adherence to value or asset-based investing. David Dreman, for example, who has written two widely read books on contrarian investing, writes a regular column for Forbes and manages a successful investment firm, describes it as 'buying stocks that are out of favor according to some well-defined, fundamental measures such as low price-to-earnings (p/e) ratio, low price-to-book, or high dividend yield.'

Dreman is attracted to stocks that have declined in price on the assumption that a price return to something like the mean will give him a profit, using traditional ratio analysis of yield, p/e and book to screen his list. This is more the strategy of a traditional value investor than a contrarian, though in some sense, Dreman is still being a contrarian to the 'nifty fifty' growth stock era of his apprenticeship in investments (see GROWTH INVESTING).

In reality, contrarian investing is none of these: though the tactics of a contrarian may resemble one or more of these naive descriptions, they miss the point and seriously so. Contrary thinking is most like intellectual independence with a healthy dash of agnosticism about consensus views. While it is true that if a consensus grows to be a 'herd' or 'crowd', the contrarian will flee. But not necessarily to the exact opposite. Instead, identification of a herd charges the contrarian to be more rigorous in independent thinking. And the contrarian is more likely to be attracted to a point of view that has not yet been thought of - the 'empty file drawer' idea - than one that has been considered and rejected.

Contrary ideas usually guide broad strategies rather than specific investments. For example, in the late 1990s and early 2000s, Russia might be seen as providing excellent contrary opportunities in the aftermath of its 1998 debt default and currency devaluation and the subsequent flight of capital.

Timing is not usually indicated by a contrary approach. And because true contrary ideas are not an automatic knee-jerk reaction away from the consensus, there can be a number of different, good, contrary reactions to the same challenge. All may be appropriately contrary.

Contrarian investing guru: James Fraser

Contrary thinking is as old as philosophy. More recently, Charles Mackay's book Extraordinary Popular Delusions and the Madness of Crowds placed the emphasis of independent thinking clearly on investments. And the late Humphrey Neill, known as the Vermont Ruminator, developed the modern approaches of contrary thinking, founded on the simple yet powerful idea that 'when everybody thinks alike, everybody is likely to be wrong'.

Neill's appointed successor, James Fraser, has extended his work: continuing to write newsletters, The Contrary Investor and The Fraser Opinion Letter, managing funds in the style; organizing an annual conference - a blend of investment professionals and individuals burying their bags of silver coins in the backyard; and running a publishing house that specializes in reprinting various investment classics, such as the Mackay book. (At the back of this book is a list of ten of his favorites.) Fraser's Fall conferences at the century-old Basin Harbor Club resort on the shores of Lake Champlain bring out new ideas and attract the best of the US investment world.

Fraser's descriptions of his newsletters' aims neatly sums up his approach to investing. The aim of The Contrary Investor is to: '1. Watch and report popularity in shares. 2. Report on neglected shares. 3. Give psychological overbought early warnings, when we detect them. 4. Comment on Crowd approach to market. 5. Guide subscribers away from the Crowd. 6. Endeavor to ferret out an occasional contrary vehicle for a small portion of your funds.' While The Fraser Opinion Letter offers: 'Thoughtful analyses upon 1. prevailing politico-economic conditions, 2. crowd psychology, and 3. popular opinions and predictions, wherein fundamental and human approach opposes mechanistic methods of forecasting.'

Counterpoint

If contrary thinking is so good, 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 speculative orgies. Second, it can be very uncomfortable to be wrong and contrary at the same time: the humiliation of going against the crowd when the crowd is right - and that can happen - is devastating. And third, much of our training and socialization teach us that the majority is right, or at least, that it rules: contrarians are out of step or at least did not get that message when they were growing up.

Is contrarian strategy profitable? There is some indication that formerly 'loser' stocks perform better than 'winners', but is this because they are riskier? And what about the transactions costs of short-run contrarian strategy? The quantitative evidence on these questions, as in most investment documentation, seems to depend on the case the researcher wishes to support more than the case itself. Nowhere is the adage, 'if you torture the data long enough, it will confess to anything', more clearly observed than in the examination of investment techniques. But a mixture of contrary instincts and investment skills seems to be a part of most investors we admire.

Finally, is contrarian strategy inconsistent with the concept of market efficiency? (see MARKET EFFICIENCY) The efficient market hypothesis (EMH) in its strong form contends that security prices are always correctly assimilating information. Today, investors generally expect that the weak form of EMH is operative, which means that sometimes it is possible, with generally available information, to gain an advantage over other investors. Contrarians look for these small opportunities by noting when the consensus seems to be clustered and they examine the other, independent alternatives.

Where next?

Contrary thinking can be a challenge to assumptions that are so deeply embedded in our understanding of the world that we often do not even realize they are there. Three contrary questions in particular may be helpful in guiding us to contrary answers. Contrarians should ask questions like these that are often not even being considered.

The first is, why do investment markets assume that growth should be the sole objective of economic enterprise? Primarily, because of a fifty year expansion in bull markets, but, in most cases, the pursuit of growth does come with the possibility of volatility and risk. Stability and survivability can also, under some conditions, be worthwhile objectives. Contrarians are likely to value these features, which are considered valueless by other investors. Corporate control through proxy voting, for example, is often considered valueless and even a potential conflict for a manager in his client relations. And yet, in a merger or acquisition environment, proxy power is quite valuable: some studies have estimated it at about 15% of total share price. Contrarians might be quicker to identify these underlying mispricings.

Second, we are raised on the notion of continuous time. Nobel Laureate Robert Merton (see RISK MANAGEMENT) wrote a fundamental text with that idea in the title. We learn that time is a horizontal axis on a time chart with each unit of time connected to its neighbor and all units of equal space and importance - time is continuous, time flows, time moves on, time in any one period is connected with any other period, time reveals trends. But in the physical world, time may be discontinuous and unconnected with any other time period - sometimes coming in bursts, separate packets of information, unique in themselves. And investment time could be like that: Humphrey Neill wrote 'sudden events quickly crystallize opinion'. Our assumptions about time having a root in the past leading to clues about the future may be wrong.

Third, there is the built-in notion of an equity premium. After a fifty year period of expansion, we take it for granted that equities produce higher returns because they have done, and we think that this is because they have higher degrees of risk. Are we prepared for the time when risk produces lower returns for equities? Or that, on closer examination, risk itself becomes something other than volatility but risk of loss and risk of being knocked out of the game?

Read on

In print

David Dreman, Contrarian Investment Strategies: The Next Generation
James Fraser's newsletters, The Contrary Investor and The Fraser Opinion Letter
Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds
Steven Mintz, Five Eminent Contrarians: Careers, Perspectives and Investment Tactics
Humphrey Neill, The Art of Contrary Thinking

Online

www.deanlebaron.com - website of one of this book's co-authors - 'dedicated to exploring the changing world of global investing, with particular emphasis on the emerging markets in the former Soviet Union, China and elsewhere, and the newly developing investment tools being made possible by the internet'

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