3 Things You Need to Know About Contrarian Investing

Contrarian investing is a sub-category of value investing and requires investors to go against the grain -- which can be an emotionally challenging, yet extremely rewarding, job.

Sep 5, 2014 at 9:05AM

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Investors can follow different investment philosophies to lend structure to their investing activities: The most common are growth investing and value investing. Growth investing is largely driven by the idea that certain companies that have experienced above-average earnings growth in the most recent past will be able to continue to benefit from earnings momentum in the future.

To some extent, this approach to investing is equivalent to jumping on the bandwagon and buying what most investors also buy. A recent example would be Netflix or Facebook -- stocks that are widely loved in the investor community for their sexy products and strong earnings growth.

On the other end of the spectrum is value investing, which has been popularized by Benjamin Graham and his highly acclaimed book "The Intelligent Investor" which lays out his value investing philosophy in detail.

In a nutshell, value investing requires investors to do some serious work by reading up on the company, its products, and gathering a solid understanding of its financial statements. The investor should then make up his or her mind about the fair value, also called the intrinsic value, of the company.

If the intrinsic value estimate is higher than the current share price, the investor will buy the stock and then sell it when the share price has reached or exceeded that fair value estimate.

Contrarian investing
Value investing provides the foundation for contrarian investing. In fact, contrarian investing can probably best be characterized as a psychological state that requires the investor to block out all the noise and commentary about a certain company or security and solely rely on his own judgement when it comes to investing.

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This is often easier said than done. Constant media coverage and trading advice seduce investors to be active and stimulate them to trade. This might be good for the investor's broker as well as the taxman, but it rarely is good for the investor.

Contrarian investing, however, allows investors to act fairly rationally and without the undue influence of their emotions. Warren Buffett, among other highly successful investors, often follows a contrarian investing strategy.

1.  Bad economic times can be good times for investing
Take the most recent financial crisis (or any other asset price bubble in history) as an example: If you bought at the time of maximum panic and uncertainty -- certainly a difficult thing to do -- you would be looking at some serious gains in your portfolio right now.

The S&P 500 has returned almost 200% since its low from March 9, 2009, and if you invested only in an index fund, you would already be way ahead of the crowd.

Buying when others panic is an extremely challenging thing to do from an emotional point of view and it is viewed somewhat suspiciously, but it has worked over time very well. Eighteenth century financier Baron Rothschild, for instance, coined the phrase, "The time to buy is when there's blood in the streets," and Warren Buffett famously advised to "be greedy when others are fearful".

For instance, let's take a quick look at Buffett's opening statements of his 2010 shareholder letter (link opens a PDF) in which he advocated for capital expenditures in the face of uncertainty:

Last year – in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment. Of this amount, $5.4 billion – or 90% of the total – was spent in the United States. Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home. In 2011, we will set a new record for capital spending – $8 billion – and spend all of the $2 billion increase in the United States.

Being greedy when others are fearful has served Warren Buffett very well over time.

2. Long-term mind-set
Investing paired with emotions rarely makes for a good combination. In fact, investors would want to make rational decisions about their financial future without the influence of emotions.

If an investor thinks really long term, volatility doesn't factor in much at all. And Warren Buffet certainly doesn't care about the often unreasonable movements of Mr. Market. Investing for the long term has the advantage that you don't need to care about short-term market swings, unless you want to take advantage of them.

Consider Warren Buffett's "bet on America", for instance, where he gave a strong vote of confidence for the American economy even though most investors were still questioning the resilience of an economic recovery at the time.

He also bought a $5 billion stake in embattled Bank of America back in 2011 and has repeatedly endorsed the restructuring efforts of bank CEO Brian Moynihan while most short-term oriented investors fled the stock in 2011 and 2012 as the mortgage crisis continued to drag on.

Volatility is an expression of uncertainty and always offers opportunity, especially if you have a long-term mind-set.

3. Focus on quality companies
Contrarian investing requires investors to only concentrate on the facts and long-term prospects of a company instead of all the excitement that comes with 24-hour stock market reporting.

A company's intrinsic value can often be concealed by market panic and negative news headlines. Consider Goldman Sachs, for instance, a premier investment bank with high profitability in normalized operating environments and a pillar of the American financial system.

As the financial markets tumbled, Buffett stepped forward and bought a $5 billion preferred equity stake in this well-known bank that paid him 10% interest. Most investors didn't even want to know anything at all about banks at this time. But Buffett saw the long-term value in a strong investment bank whose intrinsic value was discounted by an erratic Mr. Market.

Buffett also bought warrants that gave him the right to purchase an additional $5 billion worth of common stock for $115 per share. Six years later, Goldman Sachs' shares trade at $180, and Buffett has shown once again that contrarian investing can be a real winning strategy as long as you concentrate on value instead of emotions.

The Foolish bottom line
One of the most successful investors of all time, Warren Buffett, is fundamentally contrarian in his approach, which should serve as a powerful reminder of how promising contrarian investing really can be.

By adopting a critical mind-set, refraining from speculation and by using panic and fear in the market to your advantage, you might already be making a name for yourself as a contrarian investor.

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Kingkarn Amjaroen owns shares of Bank of America. The Motley Fool recommends Bank of America, Facebook, Goldman Sachs, and Netflix. The Motley Fool owns shares of Bank of America, Facebook, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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