Contrarian investing means to invest against the crowd, and to be skeptical of general market sentiment.
It’s an investing strategy that rewards patience, confidence, and rationality with high returns, and is the strategy that most of history’s world-class investors applied to earn their outsized gains.
It goes against human nature to stand out, to zig when others zag, and to be in the minority for your beliefs and choices. But that’s why contrarian investing is so profitable- if it were easy, everyone would be doing it.
Fortunately though, using this strategy successfully is more about discipline than it is about raw intelligence.
This article gives an overview of how to effectively invest with a contrarian style and concludes with specific investing tactics to increase your returns and reduce your risk.
How the Crowd Invests
Dalbar Incorporated performed a study called Quantitative Analysis of Investor Behavior, where they compared the investment returns of mutual funds and individual investors in those funds between 1992 and 2011.
They found that mutual funds grew by an average of 8.2% per year over that period, while individual investors only gained 3.5% per year.
That data are from their 2012 report and the trend has continued in their later reports as well.
The reason for this huge difference is that investors consistently took money out of funds that have recently underperformed, and put it into funds that have recently performed very well.
It’s the exact opposite of contrarian investing- they’re following success that has already occurred rather than identifying success that will likely happen in the future. They’re moving away from underperforming sectors to ones that have already gone up in price, so they’re constantly investing in market tops and removing money from market bottoms.
A consistent mistake of that magnitude is literally the difference between a comfortable retirement and a sparse one.
And people do the same thing for individual stocks and other funds. They statistically move to cash after their portfolio has lost value in a market crash, which means not only do they lose value in the crash itself, but then also miss out on the recovery.
Contrarian Investing 101
To be contrarian in this context means that when most people are euphoric about stocks, you’re becoming cautious for rational, mathematical reasons.
And when most people are afraid due to recently losing money in a downturn, you’re becoming optimistic because you see how undervalued many businesses are.
Most of history’s incredibly successful stock investors- the ones that went on to manage billions of dollars- were value investors, which by extension means they were contrarian. They saw value where others did not, and they avoided expensive companies that everyone else was enamored with.
I will tell you how to become rich. Close the doors. Be greedy when others are fearful, and fearful when others are greedy.
-Warren Buffett, Multi-Billionaire CEO of Berkshire Hathaway
Value investing is at its core the marriage of a contrarian streak and a calculator.
-Seth Klarman, Billionaire Hedge Fund Manager
Value investing is one of the best ways to step apart from the crowd and to protect oneself from the unpredictable behavior of the securities markets.
-Irving Kahn, Chairman of Kahn Brothers Group, Inc.
Buy value, not market trends or the economic outlook.
-Sir John Templeton, Billionaire Investor and Philanthropist
I am always prepared to do the right thing regardless of what other people think.
-Bill Ackman, Billionaire Activist Investor
Warren Buffet is the most well-known on the list, as he has made a six-decade career out of buying boring but highly profitable companies at cheap or reasonable prices. He bought a struggling newspaper company, a chewing gum company, a bunch of banks, and a hundred other companies like that.
While everyone was loading up on overvalued tech stocks in the late 90’s, for example, he skipped that and bought 130 million ounces of silver instead, which was at its historical low point. When the financial sector collapsed in 2008, he bailed some of them out, structuring very profitable deals for himself should they recover.
John Templeton started his fortune by buying every stock that was trading for under a dollar in the American markets in 1938 (of which there were only about a hundred), when the world was becoming a very dark place under Hitler and Hirohito. This resulted in him quadrupling his money in a few years.
Seth Klarman generated better than 16% annualized returns for over three decades so far, by analyzing the liquidation value of companies, and buying struggling companies at such low prices that his risk is kept at low levels.
Irving Kahn doubled his money from the 1929 market crash. He recognized the bubble, shorted it, and made a killing, and went on to become the oldest active investor in the world until his death in 2015 at 109 years of age.
Bill Ackman is known for his high-profile short positions and activist investing. In the early 2000’s, for example, he began noticing the growing problem with credit default swaps and mortgage-backed securities, so he shorted MBIA, a major insurer of mortgage-backed securities. For several years, his investment didn’t pay off, until 2008 when the company’s value utterly collapsed and he walked away a much richer man.
The strategy of dispassionately looking for value generally places you on the wrong side of the majority, which is a good thing.
A Contrarian Example
To start, figure out the key sectors that you have knowledge and experience in.
These are the ones I personally focus on, so let’s use them as an example:
Now suppose this year, my assets are allocated equally to those six categories. I have a couple mature tech companies (one software, one semiconductor), a couple financials (one regional bank, one insurer), two industrials (one railroad, and one automation company), a bit of a gold ETF, two MLPs (a midstream pipeline, and a natural gas pipeline), and a couple REITs (a healthcare REIT and a commercial REIT).
And then, over the course of the year, my industrials and tech companies go up 35% and 29% respectively, and I use discounted cash flow analysis or another valuation method and conclude that those sectors are overvalued.
At the same time, there’s a sell-off in the REIT sector, so my REITs go down. And the price of oil and gas falls, and so the energy sector goes down. But even some pipeline companies that had little exposure to energy prices were pushed down to undervalued levels also, which to me means opportunity.
So, here’s what I would do:
I would remove some or all the capital from the overvalued sectors (which everyone else is excited about and the market is driving the share prices up), and reallocate it towards increasing my positions in REITs and MLPs (which people are largely avoiding and driving the price down, in this example).
And it’s important to note, you don’t just move against the market intuitively. If you move assets to REITs, it’s because you conclude quantitatively that they’re becoming undervalued, that their combination of dividend yield and growth is becoming attractive at the current valuation, that their fundamental value is remaining intact while their market prices are decreasing. The same is true for MLPs and their distribution yields and distribution growth.
Now, suppose a year later that, MLPs recover to normal valuations, REITs and financials become overvalued, while technology underperforms and the price of silver falls to historic lows.
Here’s what I would do:
Again, I’d calculate the fair value of some technology companies, and buy the undervalued ones. And I’d take a position in a silver ETF.
The focus is always on moving capital away from overvalued sectors and towards undervalued sectors where the bargains are.
Applying This to Index Funds and ETFs
A contrarian investing strategy works not only for investing in individual companies, but also for index funds and ETFs.
The starting point for this is to keep an eye on the Shiller P/E ratio. It’s a cyclically-adjusted price-to-earnings ratio of the S&P 500:
It can be applied to other stock indices as well, like the FTSE 100 or the Nikkei 225.
When it becomes high, it means people are overpaying for stocks, and when it’s low, it means people are underpaying for stocks. Historically, every single time the ratio was high, it resulted in stock market returns for the S&P 500 being bad over the next 20-year period. And whenever the ratio was low, it resulted in stock market returns being good over the next 20-year period.
So, when everyone else is exuberantly driving valuations to highs, a contrarian investor would grow cautious and reduce equity exposure. Likewise, whenever markets fall to historic undervaluation, and people all think the stock market is a dangerous place, a contrarian investor would happily begin hunting for bargains, buying great companies or equity index funds at great prices.
Read more about index fund valuation approaches here.
A Conservative Approach
When people think of contrarian investing, they often think of high risk, high reward strategies, but that’s not necessarily the reality.
The Big Short, a movie about guys who shorted the housing market prior to the financial crash, shows an example of high-stakes all-or-nothing contrarian investing.
Michael Burry, MD, played by Christian Bale, shorted the housing market with his fund, and due to the structure of his shorting investment, was paying massive premiums to investment banks until he was correct, which nearly unraveled his fund as investors wanted to withdraw money, until he was proven right. Him and his investors made a ton of money when the housing market collapsed.
He’s the ultimate example of a contrarian- he has Asperger’s Syndrome, and came from an outsider’s perspective (as a physician rather than a financial professional), and so he simply looked at the numbers, and rationally invested his fund’s money based on them, even though almost everyone in the financial industry thought he was insane.
Another high-profile example is Bill Ackman, described earlier. He is known for activist investing and high-profile shorts. He’ll take a short position on a company he considers fraudulent, subjecting his fund to interest payments until that company goes down one way or another, and the whole time he’ll be public about it and subject to criticism and have other investors try to oppose him and prop up those companies. It’s hardcore, and sometimes his portfolio value is cut in half, while other times it goes up dramatically.
But you don’t have to be like that to be a contrarian investor. You can do it more gently, more gradually, and more simply, if you stick to these four rules:
1) Don’t short
Leave short positions to Wall Street. When you’re wrong on short positions, you can lose money fast. Rather than buying healthy companies, shorts involve betting against broken companies. Most hedge funds that use shorts underperform the S&P 500 anyway.
2) Don’t use margin
Keep your portfolio debt-free. That takes the pressure off, and allows you to ride out long market downturns.
3) Stick to companies that have economic moats
When a company has a moat, it means it has some durable competitive advantage against competitors.
Examples include economies of scale, brand strength, network effects, cost advantages, real estate in prime locations that can’t be reproduced, regulated monopolies, portfolios of patents, and so forth.
Avoid the temptation of investing in companies that are fragile; they may give you tremendous growth but they could also cost you everything. Stick to companies that have multiple lines of defense against competitors, and so even if that company does eventually fail, it happens gradually rather than quickly.
Read more on this topic here.
4) Avoid companies with high-debt
Sometimes, an otherwise good, wide-moat company has a low valuation because it has too much debt. This can result in a good value situation, where a contrarian investor realizes that the company is undervalued, and that although it’s risky to invest, the probability is in his or her favor. If you’re taking a more conservative approach, though, avoid high-debt companies. Pretty much the only thing that can sink a wide-moat company quickly is mismanaged debt.
Check out my six principles of investing for more information on risk management.
5) Diversify appropriately
Whether you use index ETFs or buy individual stocks, having your portfolio allocated to several different sectors, companies, countries, and asset classes vastly reduces the probability of losing a major amount of capital in a short time period.
Selling cash-secured put options with the intention to buy a stock if it dips is inherently a contrarian investing strategy, and is a smart way to invest.
You’re getting paid to insure the losses of others; to buy precisely when things go down. Yet ironically, by doing so, you give yourself downside protection compared to buying equities at current market prices. By insuring the risks of others, you’re also partially protecting your own portfolio from risk.
Suppose the shares of a great company are trading at $52.30/share, and you think it’s a decent value at current prices. To buy the shares at an even lower price and to give yourself downside protection, instead of buying it now at today’s price, you can sell a put option at a strike price of $50 that expires in 6 months, and get paid an option premium (let’s say $4/share in this example), to take on the obligation of buying the shares at $50 if the option buyer wants to assign them to you before the expiration date of the put option.
If the stock remains above $50, you’ll keep your $4, and can sell another option.
If the stock dips, you’ll buy at an effective cost basis of just $46 (based on paying $50/share and receiving the $4 per share in premiums), which is considerably below today’s example market price of $52.30.
Similarly, selling covered calls with the intention to sell your shares if they spike in price is contrarian as well.
In that case, you’re getting paid to take on the obligation to sell shares you already own at a certain price.
For example, if you bought some shares of a solid company at $18.63/share, and over the last five years the shares are now at $33.15, you might conclude that they are overvalued based on a broad set of metrics. The stock price rose faster than the inherent value of the company.
In that case, you could sell a covered call at a strike price of $35/share that expires in 3 months, and receive a call option premium of $1/share. If the shares remain below $35, you’ll keep them and your $1 premium (which translates into about 3% per quarter in premium income yield), along with all dividends paid during that quarter if there are any.
If the shares go above $35, you’ll keep any paid dividends and the option premium, and sell at $35/share.This will free up your capital from this overvalued company, and allow you to reallocate it towards an undervalued company.
A lot of this article was theoretical, so I’ll ground it in a few recent examples in the real world.
In late 2014, global oil and gas prices went down because supply outpaced demand, primarily due to increases in North American output. The result was that the share prices of most energy companies tanked.
I noticed in 2015, however, that some energy companies with very little exposure to the changes in the commodity prices of oil and gas, also dropped dramatically in value.
Magellan Midstream Partners (a midstream pipeline company) and Spectra Energy Corporation (a natural gas pipeline company), were two such examples. They had great balance sheets, strong distribution coverage, and yet had dropped a lot in price. Their distribution/dividend yields and distribution/dividend growth ratios were impressive, and safe.
So in late 2015, after careful analysis, I went long on them by selling put options for them, and made a 16% rate of return on Magellan and a 22% rate of return on Spectra throughout the next year. Spectra was bought out by another company, so I’m out of that position with a big profit, and continue to be long Magellan.
I designed those positions so that I would make 15% or better returns from option income even if they stay flat all year, or even if they dipped a bit further in price, since I wasn’t trying to predict changes in energy prices. I just wanted to get paid to buy good companies at low prices.
But they both went up and so the put options were maximally profitable.
Freight railroads had a horrible year for their stock prices in 2015.
Coal, which accounts for a big chunk of their revenue, began falling in use dramatically, since it’s being replaced by natural gas. As a result, shares of Union Pacific, CSX Corporation, Northfolk Southern, and to a lesser extent Canadian National Railway (the four largest independent freight rail companies) took a nose dive.
These railroads are incredibly flexible, though. When volume goes down, they simply remove engines and labor from the equation, to constantly adjust. Every single one of them remained profitable even in the 2007-2009 major recession.
CSX looked particularly cheap based on discounted cash flow analysis, so I bought it here:
I’m not a market timer and didn’t necessarily plan for it to work out that quickly. I was expecting to have to hold for a few years for my thesis to be right, as I collected dividends and option premiums the whole time.
But the market fixed itself faster than I expected, and it ended up being a very profitable investment over a short time. I sold that investment in the $30’s and used it for the next example.
REITs became broadly overvalued in mid-2016. There were many great companies that I simply wouldn’t buy because they were not good values.
But with concerns of increasing interest rates, a broad sell-off occurred, and REITs across the board fell 15-20% within a few months, wiping billions of dollars from their collective market capitalization.
I was happy though, because I could finally find reasonably priced REITs. I sold cash-secured puts to get paid to buy Ventas (a major healthcare REIT) if it dips to $55, when it was trading at $60, after its recent fall from $75.
Now I’m getting paid a double-digit rate of return on that investment just for being willing to buy it if it falls further.
To be a contrarian investor, you gradually move money from overvalued sectors to undervalued sectors. You can do this by buying and selling stocks normally, or you can use a more elegant approach of selling cash-secured puts to enter positions at great prices, selling covered calls to exit positions at overvalued prices, and earn extra investment income along the way.
And to keep things safe, avoid short positions, avoid margin, avoid high-debt companies, and stick to investing in companies with durable competitive advantages.
Broad market valuation metrics, like the Shiller PE ratio, can give you a rough idea of how overvalued the market is compared to 150 years of historical data. This data can be used for determining what portion of your portfolio to allocate to equities in that market, whether you’re an individual stock picker or an index investor.