How To Use Contrarian Investing To Your Advantage

By | September 1, 2016

Contrarion Investing

“Be greedy when there is fear in the market and be afraid when there is greed in the market.” This insight by the legendary investor Warren Buffet conveys what contrarian investing means. It is, by its very definition, going against the crowd behavior in the stock market.

In this article, we will discuss some of the aspects of contrarian investing and how investors can use it to their own advantage.

Far from the madding crowd

Contrarian investing works on the premise that crowd behaviour is driven by psychology, media, and prevailing sentiments, as opposed to hard facts. Hence, crowds usually make mistakes. If you can go against the crowd, there is good chance of making money in the stock market.

We can see this in 2008 when there was turmoil in the stock markets worldwide. Obviously, the Indian stock market was not untouched by it. The market barometer, the Sensex, fell from its highs of 25,000 to about 9,000 in a year. Almost everyone was selling and there were few buyers, bringing prices crashing down. A few wise investors who bought in this turmoil made windfall gains when the market went up to more than 20,000 in the next few quarters. Investors who bought when everyone was selling are the perfect example of contrarian investors.

Since last year, banks are reeling under the pressure of high Non-Performing Assets (NPAs). As an estimate, the value of NPAs in the balance sheet of Indian banks is more than Rs. 5 lakh crores. This has put pressure on stock prices of all the banks. Banking stocks have taken a beating and prices have nosedived. However, the extent of the NPA issue was not even across the sector. A few banks were very deep in the NPA quagmire, while a few were manageable. Investors who bought banking stocks in 2015 were rewarded in 2016 when the government announced sustenance to banks.

Additional Reading: Pros And Cons Of Investing in the Indian Stock Market

Advantages and pitfalls

The advantages of contrarian investing are many if done judiciously. Contrarian investing can give returns beyond one’s dreams. Satyam was a classic example when its share prices plunged to less than 90% of its value when the Satyam scam surfaced. A few investors jumped on the opportunity and bought the company’s shares in bulk. They were soon to reap a windfall gain when Tech Mahindra bought Satyam. The returns were multiple times their investment.

At the same time, recognising real opportunity for contrarian investment takes expertise, study, and observation of market and economic forces. For example, when there is a secular – or long-term – decline as opposed to a temporary or cynical decline, many companies also go down despite possessing strong fundamentals and growth prospect. Contrarian investing in such firms works wonderfully. However, there are situations where the company is in real trouble and may wind up. How to separate such companies from genuine opportunities is always a challenge for investors. For example, Deccan Chronicle Holding was in a real spot when its stock prices started declining rapidly. Investors who may have taken a contrarian call on the company have lost money.

Important points for investors

Contrarian investing is going against the crowd, and this is extremely difficult for investors and professionals. Any sign of the market moving in the opposite direction for a prolonged period can test your patience. The market can remain irrational longer than you can remain financially stable or rational. Hence, take an opposing position only when you are really convinced and are ready to wait. If you vacillate, you will be doing more harm than good to your investment portfolio.

The best way to use the contrarian investing approach is to look for secular decline because of macro-economic factors. The decline may happen across the market or the sector. However, it is also true that in every market and in every sector, there are firms with strong fundamentals and solid business models. Identify these companies and invest in them. They are declining because the market or the sector may be in a bearish phase. When the market stabilises and moves up, these companies are likely the first ones to rise.

Additional Reading: Your First Steps To Investing In The Stock Market

It pays to be contrary, but only if you are sure you know what you are doing and have the patience and wherewithal to see it through to the end.

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