A contrarian equity investor looks to buy and sell stocks in contrast to the prevailing market sentiment.
This is in the belief that the tendency towards crowd behaviour among investors leads to the mispricing of stocks – providing the opportunity for the contrarian to generate superior returns over time.
The contrarian believes that stocks can go in and out of fashion and can become under or over appreciated by investors due as much to cyclicality as to structural or fundamental issues. As such, contrarian investing is often counter-intuitive in nature.
The recent fashion in equity markets has been towards a momentum style, driven by passive investment flows. Markets have enjoyed an upward trajectory since their low point in 2009 thanks in the main to the availability of cheap money and low returns for savers elsewhere.
Cost effective passive or index tracking strategies have been popular while active investing has been roundly criticised for some time. With career security in mind, professional active managers have faced a disincentive to stray too far from their benchmarks - the result quite often being index-like returns at a considerably higher cost than passive funds can offer.
Pressure to perform often leads to short-termism and the compulsion to act rather than wait for a thesis to play out.
A contrarian approach, however, is a highly active and differentiated investment style that seeks to provide above average returns over the longer term by employing the opposite approach used in passive investing.
It enjoys the advantage of being active, but is not measured in tracking errors or overweight and underweight allocations. It allows the freedom to look closely at those stocks that the rest of the market is ignoring.
Crowd behaviour and investor biases
We have all heard the axiom that investors should ‘buy low and sell high’. This seems, on the face of it, to be a simple enough directive however it is, in-fact, extremely hard to do.
The desire to be part of the winning group or to follow the crowd is hardwired into our DNA – a ‘survival instinct’ - and while extremely useful historically, it can be counter-productive in financial markets where investors end up chasing a trend, but never beating it.
For the majority, this is also where financial losses can result. It is exceptionally difficult to perfect the timing of purchases and sales.
A contrarian strategy attempts to avoid the overblown trades prevalent during pricing bubbles, caused by the indiscriminate crowding of capital.
Exponents of contrarianism should be less exposed to the stocks most vulnerable to profit taking or panic selling in the event of a crisis of confidence or market correction.
Just as it may provide lower downside risk, this style of investing seeks out ideas that should have greater upside relative to already successful and highly valued shares.