Your Investments: Think like a contrarian

By AARON KATSMAN
June 23, 2010 22:13

Smart investors lick their chops when disasters strike.

3 minute read.



A boat motors through oil floating on the surface

oil-filled ocean 311. (photo credit: AP)

Turn on the TV or radio and chances are that you will hear a story about the damage caused by the BP oil spill in the Gulf of Mexico. For savvy investors, this type of a disaster and others like it may be an opportunity to profit. While it may seem a bit crass to try and profit when birds and fish are dying – and previously pristine, white beaches are now covered in oil – smart investors lick their chops when such disasters strike.

Why? Because in the case of BP, they focus not solely on the damage caused by BP, but rather on the damage caused to BP’s stock and bond price. I want to make it clear that I am not making any type of recommendation to run out and buy BP stocks or bonds, but it’s a great example of what is termed “contrarian” investing.

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Investors who go against the general market trend are called “contrarians.”

A contrarian is also defined as an individual who believes that certain crowd behavior among investors can lead to exploitable mispricings in the securities markets. For example, widespread pessimism about a stock can drive its price so low that it overstates the company’s risks and understates its prospects for returning to profitability.

A contrarian investor would make the case that BP is the fourthmost profitable company in the world, and it has already lost more than half of its value. In addition, a contrarian would assess that even the worst-case scenario would mean that the company’s litigation exposure and clean-up costs would come to maybe two or three years of its operating income. And no one expects the company to pay up immediately; much of the litigation exposure will get tied up in the courts for years.

It was 19 years after the Exxon Valdez oil spill until the Supreme Court made a final ruling regarding Exxon’s legal liabilities. I want to emphasize that this is by no means a recommendation to buy the stock – it’s just a good example to explain the concept.

Identifying and purchasing distressed stocks and selling them after the company recovers can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out.

Backward thinking?

Unfortunately, some investors have an inverted perception of risk.

They tend to buy stocks when they have already appreciated significantly and sell them after they have already gotten crushed. However, this is the opposite of the golden rule of investing: Buy low and sell high.

Baron Rothschild, a member of the Rothschild banking family, is credited with saying: “The time to buy is when there’s blood in the streets, even if the blood is your own.” This motto has served shrewd investors for decades. The most famous of all investors, Warren Buffet said: “You pay a very high price in the stock market for a cheery consensus.” In other words, if everyone is in agreement about a particular investment, it may not be a good one.

It’s time in the market, not timing the market

For most investors, contrarian investing may be helpful to help enhance returns, but it is generally no substitute for a strategic asset allocation. Study after study has shown that investors do best if they are invested in the market and not sitting on the sidelines waiting to hit a home run. For example, if $10,000 were put in an investment that performed similarly to the S&P 500 Index from December 1990 to December 2005 and left untouched, this sum would have grown to $51,354. However, if the investor missed even the 10 best days of the stock market during that 15- year period, his investment would have grown to only $31,994. And missing the stock market’s best 50 days during that time would have led to a loss: the original $10,000 investment would have been worth only $9,030.

While buying and selling constantly and trying to time the market are not always advisable, it is worthwhile remembering that there are always opportunities in the market, especially after it has dropped. Analyze investments objectively without getting caught up in the hysteria and speculation that scares panicked investors, and you could potentially profit when common sense returns.

aaron@lighthousecapital.co.il Aaron Katsman, a licensed financial adviser in Israel and the United States, helps people who open investment accounts in the US.


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