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Contrarian Investing: How to Be Right When Everyone Else Is Wrong

- By John Engle

We often write about value investment. As most of our readers no doubt know, value investing is the practice of looking for good companies that are underpriced relative to their true value. In Warren Buffett (Trades, Portfolio)'s words:



"Price is what you pay. Value is what you get."



Sounds simple, right? Well, not really. If it were simple, everyone would do it. Clearly, it is not. In fact, Buffett's stock-picking strategy works well precisely because there will be times when the majority of market participants will have mispriced a security.

Which brings us to a couple vital questions:

  • How do we know when the crowd is wrong?
  • How can we have the conviction to be fearful when everyone else is greedy, and to be greedy when everyone else is fearful?



Contrary to what we may tell ourselves, it can be difficult to go against the grain and buy a plummeting stock while everyone else is selling. What if we are wrong and there is something genuinely wrong with the company? What if this is a value trap? To quote again, from the long-time boss of Berkshire Hathaway (BRK-A)(BRK-B):


"If you have been playing poker for half an hour and you still don't know who the patsy is, you're the patsy."



Here are some of the tell-tale signs of a contrarian investment opportunity.

High volatility

A key part of any contrarian strategy is recognizing market hysteria. In the above scenario of buying a plummeting stock, our contrarian investor wants to be sure that this is a product of an emotional overreaction on the part of market participants, rather than a fundamental repricing in the face of some new piece of information.

Volatility is a proxy for uncertainty, which in turn compels market participants to pull capital from the market. Accordingly, periods of high volatility present good buying opportunities.

By looking at "fear indices" like the VIX (the CBOE Volatility Index) we can identify exactly when we need to be greedy.

High volume

The more high-profile an asset is, the more likely it is to be traded. High trading volumes are indications of large amounts of investor interest, and therefore potential mispricing.

This phenomenon has been observed in academic studies. In a paper dating back to 2000, Charles Lee and Bhaskaran Swaminathan showed that:


"We provide strong evidence that low (high) volume stocks tend to be under- (over-) valued by the market. This evidence includes past operating and market performance, current valuation multiples and operating performance, and future operating performance and earnings surprises. One implication of our finding is that investor expectations affect not only a stock's returns but also its trading activity."



In other words, look for value in under-the-radar stocks and you minimize the risk of being swept along in a wave of hysteria.

Excessive investor sentiment

Excessive levels of investor interest (bullish or bearish) are likely to result in mispricings. These can take various forms. Earnings estimates that are significantly below what could reasonably be expected are a classic sign of excessive bearishness.

Investor sentiment surveys (like the ones carried out by the American Associations of Individual Investors) are another. Everyone wants to hold high-profile glamour stocks, or wants their peers to think that they do (which in turn leads to the high trading volumes mentioned above).

Verdict

Looking at technical indicators like these can help you override your emotions when deciding to pull the trigger on a contrarian investment and add some hard numbers to what would otherwise be a gut decision (not that intuition is not also important).

Being right when everyone else is wrong is not easy, but there are ways to make it easier.

(This article was co-authored by Stepan Lavrouk, director of research at Atreides Capital LLC and a former research analyst for Almington Capital Merchant Bankers.)

Disclosure: No positions.

This article first appeared on GuruFocus.