Is Contrary
Investing
Still A Viable Strategy?
by Richard Geist, editor
Strategic Investing
Humphrey
Neill, known as the Vermont Ruminator, acquired his name from
Dicken's Mr. Pickwick, who was fond of "ruminating on the
strange mutability of human affairs." Human affairs was
clearly the central theme in Neill's writings. As he once stated,
"the art of contrary thinking consists in training your
mind to ruminate in directions opposite to general public opinions;
and to weigh your conclusions in light of current manifestations
of human behavior."
Neill knew that investors
have always personified the stock market. It represents all our
hopes, fears, wishes, and interests. The market goes up; the
market goes down; the market is always right; the market is random;
the market is efficient; we are always trying to beat the market.
A visitor from another planet might well think that the market
possessed internal motivation, competitive spirit, and an intelligent
mind. Too often we forget that the "market" is merely
the laboratory where competing human perceptions about value
are dramatically acted out in an ever-changing arena that continuously
influences original perceptions.
The Theory Of Contrary Investing
The
theory of Contrary Opinion is based on this often overlooked
assumption that human perceptions, and the actions resulting
from these correct or mistaken perceptions, influence stock prices.
The contrary investor studies crowd behavior in order to profit
from his or her understanding of the psychology of the market.
In his classic book,
The Art of Contrary Thinking, Neill suggested that there
are certain "laws" of psychology, which underlie the
workings of contrary investing. These include the assumption
that:
1. Crowds yield to
irrational motives which individuals are more likely to suppress.
2. People instinctively
follow the impulses of the group or "herd."
3. Contagion and imitation
in groups make people more vulnerable to suggestion and emotional
propaganda.
4. Crowds act on emotion
rather than reason, easily accepting assertions without evidence.
These assumptions prompted
Neill to suggest that "When everyone thinks alike, everyone
is likely to be wrong." While Neill's book was the first
modern day formulation of contrary opinion, he found supporting
evidence in two earlier treatises. In 1841 Charles MacKay wrote
Extraordinary Popular Delusions and the Madness of Crowds,
in which he described a series of great financial and stock
market manias. To understand the impact of economic hysteria,
it is well worth your time to read MacKay's description of the
Dutch Tulip Mania, John Law's near destruction of the French
economy, and the bursting of the South-Sea bubble. In 1895, Gustav
Le Bon wrote The Crowd, a social psychological study of group behavior, which postulates a theory of mental unity of crowds. The common theme in these books is that group or herd psychology motivates usually rational, intelligent individuals to abandon their capacity for independent thinking and succumb to group pressures. More recently there have been additional books which, while not directly addressing contrary thinking, expand its scope. Both are written by value managers. Seth Klarman, in Margin of Safety writes eloquently about the philosophy that underlies value investing. Ralph Wanger, the successful manager of the Acorn Funds who buys growth at a reasonable price, also offers sage advice on outrunning the pack in his book A Zebra in Lion Country. In past columns we have also addressed the idea that investing is an unnatural act by virtue of the fact that we all have built into our psyche an evolutionary predisposition to protect ourselves by traveling in packs.
Is The Crowd Always Wrong?
Does
this mean that the public is wrong all the time?
Neill's answer was
a decisive "NO." He argued that "The public is
perhaps right more of the time than not. In stock market parlance,
the public is right during the trends but wrong at both endsSo,
to be cynical, you might say, `Yes, the public is always wrong
when it pays to be right, but it is far from wrong in the meantime.'"
Contrarian investing
means buying into weakness and selling into strength. This is
true for the general market as well as individual stocks. Contrarians
are often value investors because they seek out undervalued,
neglected, and out of favor companies in unexciting industries
and then wait for the crowd to discover them. They are also likely
to buy stocks that brokerage firm analysts lower their ratings
on if they can find value there. As soon as the crowd, particularly
the institutions, begins to drive up the price, write research
reports, and issue buy recommendations, the contrarians are already
beginning to sell.
Contrarian investors
also are willing to wait for their bets to pay off. For example,
about 3-1/2 years ago, we urged readers to buy Air Methods for
a second time after the price retreated to the $2 dollar range.
The company's fundamentals were looking very solid going forward
and we believed eventually the stock price would catch up with
the company's progress. That didn't really happen until Sept.
2001. Recently the stock reached a high of $10.72. That's a long
time to wait, but patience was worth a compound annual growth
rate of 59%. Even a growth investor should be happy with that
return, but only a contrarian with patience would be willing
to hold what many would consider dead money for that long.
One of the primary
reasons contrary investing works is that once everyone is convinced
that an individual company's stock (or the market) will continue
going down forever, there is probably no one left to sell. Similarly,
once the crowd becomes enthusiastic about a stock, once there
is unanimity, everyone who is going to buy has probably bought.
There is no one left to bid up the price. This is one reason
why extreme points in the market, when every investor is most
optimistic or pessimistic, frequently represent turning points
in the major trend. Contrary investors take advantage of this
repetitive pattern by their non-conformist thinking always using
skepticism and doubt to question present assumptions and anticipate
future changes.
We generally use several
contrary indicators to guide our market opinions. The equity
put call ratio, the ARMs index, and the Smart Money index all
have reasonably good historical records at pointing to medium
and long-term shifts in investor psychology. As they are all
currently negative (meaning bullish), we feel strongly about
the emergence of a long-term bullish trend.
Why Doesn't Everyone Use Contrary Thinking?
Contrary
thinking, as Neill formulated it, requires us to carefully and
rationally explore both sides of an issue before making any investment
decision. As this theory seems so obvious, not only as it is
applied to investing, but also to life in general, we must ask
why it is so difficult to implement. If the subjective perceptions
of individuals determine economic value, understanding the psychology
of the individual investor should help us comprehend the difficulty
in employing contrary thinking in our investment decisions.
Contrary thinking makes
significant emotional demands. It requires patience which, in
a market environment where information travels around the world
in 1/8 of a second, is difficult to mobilize. We have learned
to expect instant gratification, and when it doesn't happen,
we're quite willing to move to an arena, or different stock,
which offers a new promise of immediate success. In addition,
as long as portfolio managers are paid to perform on a short-term
basis, patience will garner lip service, but no real interest.
Investors who are guided by contrarian strategies often buy too
early and sell too early. They therefore are the object of scorn
and ridicule by the majority of the investment community, who
are seeking perfect timing. To be contrarian means that you must
be willing to tolerate the humiliation of being wrong for long
periods of time, and very few investors, retail or professional,
have this psychological capacity.
Contrary thinking also
requires a capacity for standing alone when all about you are
exerting pressure to follow the majority. Thus reading widely
enough and critically enough to make independent decisions and
believe your own opinions over respected authority is a crucial
attribute for contrary investors. To shift out of widely held
beliefs which define our identities often creates a disorganization
and reduced effectiveness in thinking. What eases this sense
of disorganization is the increased attempt to be part of the
group that is clinging to the same ideas. Remember when IBM was
aware for a long time that mainframes were being replaced by
PCs. They were unable to shift out of their insulated, corporate
ways of thinking, in part, because such beliefs defined them
as IBM and provided a sense of sameness and continuity to management.
Some think that EMC may be suffering the same fate as they face
new innovations from smaller players in the storage industry.
Do Contrarian Strategies Continue To Work?
Contrarian
investing was not designed as a panacea for beating the market;
rather it is an important skill which can help you gain an edge
on the competition. Many have argued that momentum strategies,
in fact, have a better chance of succeeding in today's market
than contrarian ones. Momentum strategies in essence say that
if the price of a stock goes from $23 to $30, you should buy
more because it is likely to go to $40. In many ways it is a
greater fool theory of investing that often works because prices
that are moving up attract buyers. The problem with the approach
is that the price movement is often a temporary aberration and
investors generally don't know when to sell.
A more significant
problem with contrarian investing is that many investors interpret
it to mean that when there is extreme pessimism in the market
it is time to buy. This works just fine in a single market. But
our recent market has really been two markets. Some sectors have
been acting well while others have remained in a bear market.
In such a contradictory situation, when most investors are frozen
in the headlights, it is hard to be a contrarian without being
wrong.
Ways You Can Be A Contrarian
There
are a number of ways you can tilt your investing style to a contrarian
approach, however, without worrying about picking turning points
in the market:
Focus your stock
selection on the difference between intrinsic value and stock
price. Very few investors perform their own fundamental analysis
these days. They rely instead on the top ten picks from various
magazines, or sell side brokerage analysts' research. You will
by definition become a contrarian if you focus your research
on the difference between what a company might sell for in the
private market versus its current stock price. The previous example
of Air Methods is a good one in this respect, as its value at
$2 far exceeded the stock price. In addition, Air Methods offered
us a catalyst for investors to stand up and take notice, as they
were about to move from an earnings loss to profitability. Interestingly,
despite this obvious catalyst, the investment community did not
jump on the bandwagon for several quarters after profitability
was achieved.
Change your diversification
strategy. Most of the investment community has bought into
the idea of extensive diversification. If you perform in-depth
research, you can significantly reduce your diversification.
As Charlie Munger once said, "there are huge advantages
for an individual to get into a position where you can make a
few great investments and just sit back and wait" This contrarian
approach means you will only find a few great opportunities,
but when you do, you can overweight your position. Most investors
who have managed to make large sums of money in the market have
done so by committing large amounts to stocks where the odds
were heavily in their favor. This strategy is clearly not without
its risks, but it also is one of the best contrarian approaches
to the market.
Embrace Volatility.
Only the contrarians love volatility. Most investors would
rather enjoy a smooth ride that lets them sleep at night. But
volatility is a friend of the contrarian because, having done
his research and maintaining plenty of cash through bull and
bear markets, he can take advantage of price drops to accumulate
choice holdings at lower prices. This not only gives him or her
a wider margin of safety, it helps to lower your diversification
while minimizing risk on the price side. Emphasize
absolute over relative returns. Nearly every money manager
and individual investor is constantly concerned with beating
the indexes. And the large mutual funds have helped to promote
this silly strategy by paying their managers large bonuses for
beating a bogey. If the S&P is down 20% for the year but
you are down only 15% for the year, you will still get your bonus.
In the industry, it's all relative. As an individual, however,
you don't get a bonus when your portfolio outperforms a negative
return index by 5%. You just lose 15% instead of 20%. So as a
contrarian, don't worry about the indexes. Make a plan for how
much cash you will need at the end of your time horizon and try
to perform up to that level. In that contrarian way, you will
remain much more focused on your individual portfolio than you
will on whether you "beat the market." Editor's
Note: Richard Geist is editor of Richard Geist's Strategic
Investing, 1905 Beacon St., Waban, MA 02468, 1 year, 12 issues,
$157. In his widely-acclaimed newsletter, Richard Geist culls
through thousands of small-cap and micro-cap investment opportunities
to select only a few, each possessing those unique investment
qualities likely to propel a reasonable investment into a lifetime
fortune. Pharmaceuticals, high-tech, and communications are just
some of the industries represented in his fully researched recommendations.
