contrarian investment

Stock investing strategy: Contrarian Investing.

Following a strategy of going against the current views of the majority investors is called contrarian investing. Why do such investors take a contrary view? Because, they believe that certain consensus among investors can lead to wide mispricings in securities markets.

For example: A wide spread negative news or rumors about a stock may send the prices of that stock crashing. These investors try to spot such stocks and invest in it resulting in above average returns.

CONTRARIAN -THE BOLD APPROACH

A true contrarian is neither bullish nor bearish on securities. A contrarian investor takes a bold approach. The goal of a contrarian investor is to profit from the mispricings that an irrational market creates. Something similar to value investing. The only difference here is that, this approach relies more on market sentiments and investor behavior. Contrarian investing has more opportunities in markets which are emerging out of a bear phase. Typically, in such markets many stocks, which have a strong growth potential, quote at attractive valuations primarily because investors widely extrapolate news flow and performance of the recent past.

MISPRICED STOCKS

Contrarian investing works because of the psychology of market participants. During the beginning of a trend, buyers are cautious, and the more seasoned players are the primary participants. As the trend gains traction, more and more investors become aware of it, deploying more capital to take advantage of the market’s strength. Then at the end of the trend, when everyone who’s interested in buying into the trend already had — with no more available capital to sustain the already inflated prices, it’s incredibly easy for a panic to make stock prices tumble down.

A perfect example of this was the 2008 market crash. The trend started and it continued till all those who were interested in buying into the trend has put in their money. Then, Stocks sold off hard, all the seasoned players made money and the crowd was left with stocks purchased at higher prices. The prices of stocks tumbled and the crowd, unable to hold on, sold their stocks suffering heavy financial loss. At this point, the smart guys step in again and then, dramatically the stock regains much of that lost ground in 2010. This was a classic case of the crowd dramatically shifting sentiment. Those who thought opposite to what the crowd thought would have definitely made lot of money.

DOES IT WORK IN INDIAN MARKETS?

Emotions play a huge part in Indian stock markets. Right from horoscopes to palm reading and tarot cards, there’s lot of ‘shastras’ that Indians rely on to take financial decisions.   Otherwise, the stock market wouldn’t have crossed 21000 in January 2008, tumble to 7600 points in October 2008 and then again cross 21000 in November 2010. More than earnings data, sentiments played a major role in this huge fluctuation.

According to Mr. Ved Prakash of Tata mutual fund, “The strategy of contrarian investing works in most markets. Contrarian investing focuses on looking at companies with a long-term potential who are out of favour either because they are misunderstood or because their short-term expected performance is below market expectations or there is short-term negative news flow which is clouding the otherwise strong potential of the business”.

So, where emotions or expectations are high, contrarian approach works well. The crowd will always be caught on the wrong side when the market turns upside down.

SPOTTING THE TURNING POINTS

So, then, if turning points are where the crowd is wrong, the biggest challenge is spotting them. You can spot turning points through fundamentals or technicals or by studying the general economic indicators.

1. Valuation

The theory behind valuation is simple. Buy when stocks look fundamentally cheap. Sell when the stock is expensive. Valuation, however, is not an easy process. It requires a strong understanding of fundamental analysis; it also requires its practitioner to attempt to make an objective decision about a subjective topic like “value.”

2. Technical Analysis

Another option for contrarians is to use technical analysis to spot reversals. Momentum, trend breaks, volumes, RSI all come into play here.

3. Quantitative and Economic Indicators

The last method skips looking directly at a security’s price and looks at broader economic indicators such as volatility index to spot turnarounds.

CONCLUSION.

Tracking these indicators- not any one of them –but all of them together, may help you to take a contrary position before the market starts to correct itself. Successful contrarians realize that turning points are key. So next time, I hope this little advice would help you to avoid getting trapped in a market crash and at the same time help you to spot turnarounds and profit from it.