How A Contrarian Investor Can Profit

To be a contrarian investor requires you to do something basic: the opposite of everyone else! Stock prices are pushed up and down by flows of money. If the investor community thinks a sector or stock is attractive, they will pile in, driving up it's price. This can work in reverse, where investors react with panic to a negative report and sell out. In both cases opportunities present themselves. 

Takeaways

• The aim of a contrarian investor

• How a contrarian operates

• Why doing the work allows you to have confidence

What is a contrarian investor?

A contrarian is someone who does the contrary to everyone else. In investing terms, this means they will invest in areas that others are negative about. They will do so in the belief that others have either been too negative, or that by getting in early they can profit when other investors start buying in.

Theoretically a contrarian investor is buying when everyone is selling, and selling when everyone is buying. This has some logic, buying a stock when it has already jumped upwards means you will be buying when everyone has already made their money. The fear of missing out is an example where emotion leads to poor decisions.

Seeing an opportunity

Warren Buffet once said to be "fearful when others are greedy, and greedy when others are fearful." This is classic contrarian territory. Spotting undervalued stocks is not hard when you perform fundamental analysis. The difficulty is having the timing and courage to buy. Although there are technical aids, such as the 200 day moving average, experience counts for the most.

Wise old owls have an advantage over eager beavers.

When you have researched a stock and understand how it makes it money, you should watch the share price on a regular basis. By doing so you will gain an understanding of how that share price behaves in relation to events. In time you will understand what is day to day volatility, and what is outright emotionally driven panic selling. That is the time to buy and make some money.

Good news is bad news

This may sound a little perverse, but contrarians prefer sell offs rather than stable markets. Indeed contrarian investors do not like a market rally. During times of limited volatility or a market trending upwards, contrarians will research companies and build up knowledge, ready to take advantage of opportunities that might present themselves.

As previously mentioned, it can be scary to buy into a share which has fallen 20-30% in a short period of time. Yet if you understand what has happened and what others have missed, you will not need courage to help you invest, your knowledge will do it for you.

Benefit at the expense of others

Boohoo is a highly rated company, which has successfully tapped into the need for the younger generations to have the same clothes are their celebrity idols. Yet the share sold off 50% in a few days when Boohoo was criticised for working practices.

Although the concerns expressed are serious and real, any investor needs to have a healthy dose of cynicism. It is unlikely that firms selling clothing for a couple of pounds can do so without cutting corners somewhere. Although today's society preaches a great deal about looking after others, this is not reflected in how society spends its income.

How does one explain the large amounts of money spent on Boohoo and ASOS by clients? ASOS has also faced accusations of taking advantage of its staff. The simple fact is, people are quick to criticise these bad working practices, but equally as quick to buy their latest offering. As an investor you should develop an ability to read between the lines and know how to tap into megatrends.

A contrarian's move

Boohoo's shares sold off due to the concern they were underpaying their staff. The concern was their margin would come down as they were forced to pay the minimum wage. This meant an increase in costs.

From a contrarian investor's perspective, there were two key area to focus on, Boohoo's financials and it's share price. Although Boohoo's shares were expensive prior to the sell off, a 50% fall in a couple of days is normally caused by a major profit warning, not an accusation of underpaying staff.

This meant the shares had been over sold, especially as Boohoo's financial statements showed a large cash balance, more than enough to be a going concern for a while. A contrarian investor would have noticed this. The share promptly bounced +30% the day after the shares reached -50%.

Conclusion

It would be easy to point that out the Boohoo situation is still a developing one, but with a recession coming as a result of Covid-19, the likelihood is that impressionable 20 and 30 somethings will prefer to pay less and look like celebrities, rather than buy ethically produced and costly garments.

Although this example is now behind us, it shows the benefit of knowing a company, having a feel for what it does and understanding how its share price behaves. Knowledge is a contrarian's key advantage but you should still be wary.

There is a risk with contrarian investing that you are trying to catch a falling knife. That is why a margin of safety is advisable. Rather than pilling in with a large position, it is better to start small and once you see the stock rebounding or momentum trading take hold, then increase you position.