How to be a good contrarian investor

Tuesday 22 December 2020

Yesterday we looked at the recent track record of the team at Stocks Down Under when it came to some of our contrarian plays. That prompted us to ask if it’s possible to train yourself to become a good contrarian investor. We think it is. Contrarian investing is a strategy which, if practiced well, can make you a lot of money. Take the gold miners as a good example. In 2001 everyone you talked to seemed to hate gold and had come to view it in the same way as Keynes had back in the 1920s: to wit, as a ‘barbarous relic’. Gold was under US$300 an ounce, and you could buy Newcrest for under A$3 a share. The contrarians were rewarded over the next decade in a big way. In 2011 gold was more like US$1,550 an ounce and Newcrest had been to $40 a share.

Fifty million investors can’t be wrong

But how to be a good contrarian? In our experience it’s a lot harder than you think. Most human beings are not naturally contrarian. We like to take our guide on ‘right’ and ‘proper’ thinking from the people around us and the more people that think a certain way, the more compelling their viewpoint is. Indeed, it has always been so. That hit song entitled ‘Fifty Million Frenchmen Can’t Be Wrong’ came out way back in 1927. And, indeed, a lot of the time it makes sense to follow the lead of someone else.  It’s the reason, for example, why we have restaurant reviews, or book reviews. If a few people said it was okay then it reduces the chances that I’ll waste my time and money and look silly in front of other people. If a lot of people said it, then it can’t possibly be anything but true, right?.

The market, however, teaches us that things are not always what they seem, as the Newcrest example will have shown. So how to be a good contrarian?

The first step is to remind yourself that, from time to time, people will come to believe really stupid things. So, we’d start by reading that 1837 folk tale from Hans Christian Anderson called ‘The Emperor’s New Clothes’. We’d then turn to that remarkable non-fiction book from 1841 by the Rev. Charles Mackay entitled ‘Extraordinary Popular Delusions and the Madness of Crowds’, which gives a few real-life examples of the Emperor’s New Clothes from history, including the Salem Witch Hunts and the Dutch Tulip Bulb Mania. After that we’d look at Manias, Panics and Crashes, Charles Kindleberger’s masterly 1978 history of financial crises for more examples from the financial world.

You have to put in the work to be a good contrarian

We’d then encourage you to start training your mind in contrarian thinking. If you were on the debate team in high school you will have already done this, because in debating one has to be ready without notice to take the contrary view to a question even if one doesn’t truly believe it.

The best training exercise in contrarian thinking is this: You read a number of generally negative (or positive) stories about a stock somewhere. You then ask yourself, what would turn this situation around and whether the turnaround is underway. You write that logic down.

Finally, you ask if the stock price has already compensated by dropping below (or risen above) the level a proper valuation would warrant. You check the cash flow statements and the balance sheet to see if the company isn’t going broke. And then you keep listening to what the bears (or bulls) have to say on the story. The louder the sentiment, the more you pay attention to your thesis. Finally, at the point of maximum negativity (or positivity) versus bargain basement pricing (or exuberant valuation) you pull the trigger.

Sure, easier said than done. But the payoff is surely worth the effort. Burns Philp was privatised in 2006 at $1.10 per share. Back when it was truly hated around 1997 you could get it for a mere 7 cents or so.

Further reading:

• Contrarian Investment Strategy: The Psychology of Stock Market Success by David Dreman
• Contrarian Investing by Anthony Gallea and William Patalon
• Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations by Tobias Carlisle
• Beat the Crowd: How You Can Out-Invest the Herd by Thinking Differently by Elisabeth Dellinger and Kenneth Fisher
• The Triumph of Contrarian Investing by Ned Davis

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