Through careful analysis, the right timing and expertise, a contrarian buying approach can make a fortune for investors

Be fearful when others are greedy, and be greedy when others are fearful.” This statement by the famous investor Warren Buffett puts in a nutshell the concept of contrarian investing. It is an approach that has benefited many successful investors like Buffett himself and billionaires like Peter Lynch and John Templeton, to name a few. Contrarian investing is an approach that follows rational behaviour when the popular sentiment on the bourses is irrational. Contrarian investors go against the prevalent market sentiment and invest in stocks and sectors that have vast growth potential in the long run but are currently undervalued due to a short-term negative sentiment. The stock market is made up of traders and investors. Traders have a short-term view and invest based upon the temporary ups and downs which are created by positive and negative news and investor sentiments. Stocks which are not fundamentally strong get overvalued in a bull phase and scrips, which are intrinsically strong, get beaten down in a bear phase. This definitely does not mean that every stock that is overvalued is strong or every scrip that is undervalued is fundamentally weak.

A long-term or fundamental investor identifies healthy companies whose share value increases proportionately as the business grows and invests in them. Many times, due to temporary economic conditions, war, or pandemics, stock markets enter an extended bear phase. During this time, all stocks, strong or weak, take a beating and their values go down. This time is marked with extreme pessimism where all investors panic, behave irrationally and start selling their shares. The general view is that such times are unsuitable to start investing in scrip. However, this view is not shared by the contrarian investors, who look at the beaten market as an opportune time for bargain hunting and invest in stocks that have strong fundamentals.

These contrarian investors reap huge benefits when the negative sentiment settles down and the market starts its upward journey, making their investments multi-baggers.

The 2008 economic crisis is one such instance when the investors across the globe went into panic selling mode, leading to massive selling on the global bourses. Shares of fundamentally strong companies were available at huge discounts. During this time, contrarian investors avoided the herd mentality and picked up beaten but healthy companies and subsequently enjoyed significant returns during the recovery phase. The main strength of a contrarian investor is to identify scrips that are fundamentally strong but undervalued. They use financial ratios like low Price to Earnings (PE), Price to Book Value, Price to Cash Earnings and other financial ratios to discover undervalued stocks. Over the years, contrarian investors started using several additional ratios like Earnings to Price (E/P), they use Book to Market (B/M), Cash Flow to Price (C/P) and Past Growth of Sales (GS) to ascertain the value of firms. Studies regarding contrarian investing can go back as far as 1977 when Basu analysed the performance of US stocks, based on their PE ratio, for a period of 14 years from 1957-1971, and found that lower PE stocks generate higher returns when compared to higher PE scrip. Here are some contrarian investment strategies that are followed by most successful investors. Swim against the tide: As humans are social animals, almost all of them are bound by social confirmations. When a majority of people believe in something, it is thought to be true. This herd mentality is also visible in stock markets during a bear or bull phase. Investors tend to follow others either in panic selling or buying, irrespective of the valuation of the shares. So they end up either buying overvalued or selling undervalued stock. Contrarians, on the other hand, have independent thinking and do not follow the crowd. They make investment decisions based on the fundamentals of the stocks.

Seeing opportunity in a crisis: For irrational investors, a market crash is a bad news as they panic and follow the herd. For contrarians, every market crash is an opportunity. They wait for the downward slide in the market to buy good stocks at a bargain. 

Be a long-term investor: Contrarian investors believe in long-term investing. They pick up great stocks when they are undervalued and wait patiently for the prices to go up.

Research: Due to changing economic and business scenarios, a contrarian investor should not depend only on the past performance of the scrip. Research has to be continuous as many stocks that were considered intrinsically strong earlier are nowhere to be found now. If a company is showing continuous downfall in financial performance, it is better to exit the stock and look for an alternative.

Any investment style is not without its pitfalls, and so is contrarian investing. It is hard to practise, as going against the general market sentiment is never easy and is often marred by self-doubt. Despite having the backing of research and careful analysis, contrarian investing does not guarantee success. Even a shrewd and experienced businessman like Buffett lost $443 million by investing in Dexter Shoes in 1993, that was making year-on-year profit, but went out of business in 2008 as competition increased.

To conclude, contrarian investing is a technique practised by a handful of investors who have the expertise and rationality to pick intrinsically-strong bargain stocks, and extreme optimism to see hope in market downturns. Through a careful analysis, the right timing and expertise, a contrarian investing approach can make a fortune for investors.

(The writer is Associate Professor, Amity University, Noida)