This is part two of our trading strategies mini-series. In the first part we briefly discussed value investing, and finding those attractively priced stocks being overlooked by most of the market.
We are now going to talk through the contrarian approach to investing, or doing what most of the market isn’t.
GOING AGAINST THE GRAIN
Doing the opposite of what the vast majority of investors are doing will always feel counter-intuitive, so it takes sturdy investment discipline.
A contrarian investor ignores market trends and buys neglected and depressed stocks of, typically, well-managed companies that for one reason or other have fallen out of favour. It’s an investment style that is not entirely dissimilar to the value chaser.
The contrarian tends to look for strong trends in the market and take an opposing view, buying shares in healthy companies stuck in unpopular industries.
The idea is that as unpopular share prices fall they become more value attractive than rising ones and, with patience and a bit of luck, in time this trend will reverse. By buying out of favour shares the contrarian can ride the subsequent uptrend, as they regain popularity, from much closer to the ground floor.
There was a classic example of this in the late 1990s, when anything with a dot.com in its name went flying higher. At the same time, share prices of mature, often called old economy businesses, just kept on sinking.
CONTRARIANS WON THE DOT.COM WAR
While there was plenty of internet money to be made around that time, there’s no doubt that contrarian investors had the last laugh.
Shares on low price to earnings ratios (PEs) (read this to understand what a PE is) are particular favourites with contrarians, although you need to watch out for signs that a low share price is really undeserved.
Contrarians need to look closely at a company's balance sheet and cash flow reports to ensure financial stability, and the management strategy if they're to spot companies that can genuinely survive through a potentially prolonged spell in the doldrums ahead of returning to fashion.