3 Basic Rules for Making Smart Contrarian Investments

Being contrarian pays when you’re an investor.

If nobody wants an asset, you can buy it cheap. If everybody wants it, it’s expensive.

But as Michael Lewis, bestselling author of The Big Short and a former bond salesman for Salomon Brothers, puts it, “On Wall Street everybody says he’s a contrarian, and nobody is.”

Investors love to follow the herd. And most of the time, “fighting the trend” is difficult at best. If you immediately take the opposite side every time a stock gets overvalued or a sector looks oversold, you’re going to go bust very quickly.

The past decade has shown this dramatically. Today, I’ll show you why. I’ll also share three basic rules for making smart contrarian investments – so you can avoid losing money on low-quality stocks…

Even at the times when a contrarian opinion is correct, most investors don’t have the courage to make the trade.

Every investor professes a contrarian streak, but when watching a dropping market, they often say, “I know you’re supposed to be greedy when others are fearful… but things are pretty scary right now.”

If you had the guts to buy in March 2009 – with the S&P 500 Index trading around 12 times earnings… then you earned your contrarian merit badge.

But I hope you haven’t had the contrarian itch since then. Most asset classes have risen steadily for the past nine years. Taking a contrarian perspective of the broad market and focusing on short-selling wouldn’t have done much for you.

You would have had a few opportunities as trends reversed. You could have gotten out of oil stocks in early 2015… shorted blockchain stocks when bitcoin prices neared $20,000… or maybe sold out of a few high-flying holdings like Valeant Pharmaceuticals (VRX) before they crashed. But in general, “trend following” ruled the decade.

This doesn’t just apply to long versus short trades. It also applies to value versus growth…

Every study on stock market factors shows that, over time, buying low-priced stocks (as valued by either the price-to-earnings or price-to-book ratio) tends to outperform buying more expensive stocks. So finding overlooked bargains tends to be the better long-term strategy. But not this decade.

As you can see in the following chart, comparing the Russell 1000 Value and Growth indexes shows that value simply hasn’t worked…

For the past decade, it has paid to be a follower. And even if you wanted to make contrarian investments, you would have been hard-pressed to find one while the rising tide lifted all assets.

That’s why you must understand the three rules we follow for contrarian investing. Buying something just because it’s down does not necessarily pay off.

To be a successful contrarian, you need to…

1. Understand why the price has dropped.

Most of the time, stocks fall for a reason. You need to understand your investment well enough to know what that is… and have a good rationale for why it’s an investor overreaction.

2. Buy cheap – real cheap.

This doesn’t mean just buying 20% below an all-time-high. This means looking at measures of value, like the price-to-earnings ratio – and specifically, looking for significant, historically low valuations. That way, if you missed your contrarian opportunity the last time an asset was dirt-cheap, you’ll know with conviction that you’ve got a second chance.

3. Only buy quality businesses with real earnings power.

A dying, money-losing business – even at a cheap price – doesn’t make a good investment. So if an entire sector is down (and you believe it’s an overreaction), step in and buy the best operator in that sector.

With these rules, we can protect ourselves from getting sucked into a “value trap” (which is when a cheap stock really isn’t a good deal, because you overlooked the good reasons it was cheap).

Plus, they’ll make sure we earn the maximum returns for making a gutsy, contrarian bet.

Good investing,

Dr. David Eifrig

Source: Daily Wealth