Contrarian Investing – How to Profit From Going Against the Crowd

Contrarian investing involves buying undervalued assets. It reconciles investing independently and finding undervalued assets through research with a quick decision. It represents a staunch independent investing stance based on research and because of that, it is in the first quadrant. The main purpose of contrarian investing is to identify undervalued assets before they become popular investments.

It’s in the nature of undervaluation of an asset that it takes time before the market recognises the value of the item; so it can be a long-term play but, done right, it can still be lucrative.

Identifying undervalued stocks

Identifying these types of stocks demands both patience and research into fundamentals, yet the payoff can be huge because such stocks tend to trade for less than their inherent value, which can be assessed against financial metrics such as earings and growth prospects. Short-term volatility in the market or unexpected news could cause a stock to trade down from its true intrinsic value and make it difficult to determine if a stock is indeed undervalued.

A good way to find undervalued stocks is to compare their price-earnings ratios (P/E) with those of other, comparable companies within industries. This enables you to

One method to identify undervalued stocks might be zeroing in on companies with strong dividend yields and cash flows that are temporarily out of favour or experiencing a structural shift. This approach would make sense if you were trying to land a high-quality stock at a value price that might generate some dividend returns over time. Get exposure to companies with simple balance sheets, low debt levels and strong cashflows, and you might find true green shoots.

Investing in undervalued stocks

Buying undervalued stock provides excellent portfolio diversification. Market participants tend to be short-sighted when it comes to such stocks because they focus on short ­term indicators, like decreasing sales or shifting business focus. Intelligent investors grasp the long-term growth of such enterprises, and profits are big for holders of those stocks.

During the tech bubble of the 1990s, many internet-related stocks became overvalued on conventional measures. Contrarian investors sensed that there was likely to be a return to mean reversion in market trends, and avoided buying into these overpriced assets, which subsequently saw steep price declines.

The exact timing of your trades is essential to your success, so make sure to use indices and tools (such as technical analysis and market momentum) to time the market, as well as simulated or practice trades to build up your strategy so you can execute your trade without putting real financial exposure at risk. (Another way to mitigate your risk exposure would be to use a roboadvisor for your investing needs.)

Investing in undervalued sectors

Contrarian traders know that attempts to time a market tend to come to grief, but they do keep an eye on sentiment levels – via a measure such as put/call ratio, or in social media – to try to pick up times when enthusiasm about a market has become too stretched (or the opposite when selling dominates), but they must be careful to select a stop-loss level. Execution of the trade might be via a technical entry such as a double top (a chart pattern that can pick up when a trend has become exhausted). Get any of the above badly wrong, and the money-losing is often swift, and often very painful.

This is part of the art of being an effective contrarian. A contrarian needs to have the ability to think for herself and come genuinely to her own conclusions, since this is the only effective way to truly do good things in the world; moreover, this is often very lucrative as well. (Some of the biggest returns during the pandemic of 2020 were people who saw, while others dismissed ‘Big Pharma paid shills’ telling them that masking, and vaccination, were good ideas for them.) This is called ‘advantageous divergence’, and it holds true in business as well as in music, and offers lessons from both.\

Investing in undervalued countries

Picking cheap countries might take years to bear fruit, but it could produce above-average returns. It’s worth taking the time to do detailed research and to ensure that your strategy is clear and transparent – you don’t want yourself or your successors to back away from a valid investment thesis, so write down your investment strategy and stick to it. You have earned the confidence of investors, don’t betray them. When everyone realises what you have discovered, be patient and let your investment thesis play out.

Contrarian traders try to capitalise on the extremity of market sentiment at a given time. For example, during the late 1990s in the midst of the dot-com bubble, many internet-related companies were trading at very high multiples of profit, which by standard measures was incongruent with the fundamentals of the companies. But the fervour generated in the market reflected the rationale behind the high prices. This expansive optimism eventually led to contrarian investors deciding to take ‘short’ positions. Shorting means they sell stocks that they don’t own, expecting the price to fall and then picking up shares at a lower price and returning them to the broker. Shorting is akin to betting against a company. While the internet sector kept growing, contrarians lost money. However, as the bubble began to burst, their bets paid off and they were proved right.

For one thing, contrarian traders see bad news as an opportunity to buy an asset at a bargain, when investors’ emotions cause stock-market sell-offs after disappointing announcements from companies such as pharmaceuticals with an underperforming new drug. They know that investors’ overreaction is apparent in the stock price declining far past the intrinsic value of the company. Rational investors can then snap up shares in the bounce back.