Contrarian Investment Strategies: The Next Generation

Contrarian Investment Strategies is primarily about the four strategies of buying stocks with high dividend yields or low P/E (price-to-earnings), P/CF (price-to-cash-flow), or P/B (price-to-book-value) ratios, and how they outperformed the market in the past.

My impression of Contrarian Investment Strategies is mixed. On the one hand I found the (psychological) explanations about why these strategies seem to work interesting. On the other hand, the book is too long with its more than 400 pages. Especially the author's criticism of the efficient market hypothesis goes on and on, and I think it would have been better to put this stuff into another book for those interested in such a debate.

My notes

Introduction

It is not enough to have winning methods, we must be able to use them. It sounds almost simplistic, but it isn't. Sure, the methods are easy to understand and initiate. But most investors, whether professional or individual, even with the best of intentions, cannot follow through. There is an enormous but little recognized barrier in the way – investor psychology.

The success of contrarian strategies requires you at times to go against gut reactions, the prevailing beliefs in the marketplace, and the experts you respect.

The major thesis of this book is that investors overreact to events. [...] Under certain well-defined circumstances, investors overreact predictably and systematically.

Why Current Methods Don't Work

The Sure Thing Almost Nobody Plays

Scientific progress advances funeral by funeral.

The key principle of this book is that people are not the rational, omniscient decision-makers that the efficient market believers claim, and most investment practitioners believe. Rather, we are constantly pushed or pulled by psychological influences.

From Technical Analysis to Astrology

The efficient market hypothesis states that stock prices reflect everything known about a company, an industry, or the economy as a whole. This simple academic proposition has some staggering implications when you think about it. It implies that stock prices cannot be predicted, that everything known about a stock is already reflected in its price. Prices will only be moved by events that can't be foreseen.

Technicians believe stocks and the general market move in discernible trends that continue until they clearly signal a change in course. Because stocks never move in a straight line, but invariably retrace a portion of each advance or decline, the analyst must be able to filter the useful information from the vast amount of static.

Trend lines are essential to the chartist, because of the paramount principle that a trend once started does not easily change course. A change in trend, or a reversal, the technicians believe, can be recognized by diligent study of the charts. Spotting a change quickly allows them to protect their positions and to benefit from the new market course. This belief is fundamental to the technical method.

No matter how convinced the technician is about the market's or a stock's next move, he has no more chance of being right than by tossing a coin. When a coin is tossed, even if it comes up heads ten times in a row, there is still a 50-50 chance that it will come up tails on the next throw. Or, in market terms, if a stock closes higher for ten consecutive days, the next day the stock has a 50-50 chance of closing down.

Rule 1: Do not use market-timing or technical analysis. These techniques can only cost you money.

Bigger Game Ahead

In essence, the fundamentalist holds that a company's value can be determined through rigorous analysis of its sales, its earnings and dividends, its financial strength, and a host of related measures. To value a stock, the analyst tries to evaluate all relevant information, often supplementing his work with visits to the companies to meet with senior management.

The fundamentalist believes that stock prices can diverge sharply from their real worth. His methods allow him to search out the true value, buying solid companies that are underpriced and selling those that are overpriced. The market, he is convinced, must eventually recognize the error of its ways and correct them.

Since meaningful information enters the marketplace unpredictably, prices react in a random manner. This is the real reason that charting and technical analysis do not work. Nobody knows what new data will enter the market, whether it will be positive or negative, or whether it will affect the market as a whole, or only a single company.

The Expert Way to Lose Your Savings

Dangerous Forecasts

As a society, we have always had a schizophrenic attitude toward experts. On the one hand, when we want their help, we rush to them, and breathlessly await their utterances. But if we don't need them and look objectively at their performance, our attitude is often less reverential and more colored with amusement, or even downright skepticism. With good reason. Experts are often wrong – sometimes remarkably so.

[...] keep in mind that when we ask an expert for a forecast, we're asking him to read the future.

Earnings forecasting [...] depends on large numbers of underlying assumptions, many of which are rapidly changing and hard to quantify – which means their accuracy is always in doubt.

A large number of studies show rather conclusively that giving an expert more information doesn't do much to improve his judgment.

Rule 2: Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits.

Rule 3: Don't make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.

Confidence rises as our input of information increases, but our decisions do not improve.

Rule 4: Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.

Would You Play a 1 in 50 Billion Shot?

Rule 5: There are no highly predictable industries in which you can count on analysts' forecasts. Relying on these estimates will lead to trouble.

This is an important finding for the investor: if analysts are generally optimistic, there will be a large number of disappointments created not by events, but by initially seeing the company or industry through rose-colored glasses.

Rule 6: Analysts' forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimate.

Rule 7: Most current security analysis requires a precision in analysts' estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

Rule 8: It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past to estimate the future.

Rule 9: Be realistic about the downside of an investment, recognizing our human tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.

Nasty Surprises

Earnings surprises, whether positive or negative, affect favored and out-of-favor stocks very differently. Surprise consistently results in above-average performance for out-of-favor stocks and below-average performance for favored stocks.

Rule 10: Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.

Why do positive surprises for "best" stocks cause only a moderate rise in the surprise quarter? Since analysts and investors alike believe they can precisely judge which stocks will be the real winners in the years ahead, a positive surprise does little more than confirm their expectations. It's no great shakes – the top companies should have rapidly growing revenues, market share, and earnings. By the end of the year, therefore, the effect of the surprise almost disappears. Investors react very differently to positive surprises for out-of-favor companies [...]. Investors put these stocks into the lowest category precisely because they expect them to continue to mope. These are the dogs of the investment world; they deserve minimal valuations. A positive earnings surprise for a stock in this group is an event. Investors sit up and take notice. Maybe these companies are not as bad as analysts and investors believed. Out-of-favor stock, therefore, do not just move up in the quarter of the surprise and then drop back again, as do the favorites. Instead, they continue to move steadily higher relative to the market in the year following the surprise.

Investors have low expectations for what they consider lackluster or bad stocks, and when they do disappoint, few eyebrows are raised. The bottom line is that a negative surprise is not much of an event in the surprise quarter and is a non-event in the nine months following the news. Consider the "best" companies, however. Investors expect only glowing prospects for these stocks. After all, they confidently – overconfidently – believe that they can divine the future of a "good" stock with precision. These stocks are not supposed to disappoint; people pay top dollar for them for exactly this reason. So when the negative surprise arrives, the results are devastating.

Rule 11: Positive and negative surprises affect "best" and "worst" stocks in a diametrically opposite manner.

I define an event trigger as unexpected negative news on a stock believed to have excellent prospects, or unexpectedly positive news on a stock believed to have a mediocre outlook. The event trigger results in people looking at the two categories of stocks very differently. They take off their dark or rose-colored glasses. They now evaluate the companies more realistically, and the reappraisal results in a major price change to correct the market's previous overreaction.

Event triggers can result from surprises other than earnings. A non-earnings surprise might be the approval by the FDA of an important new drug – or its denial of further testing.

Reinforcing events are defined as positive surprises on favored stocks or negative surprises on out-of-favor stocks. A positive surprise on a favored stock reinforces the previous perception that this is an excellent company. [...] A reinforcing event has only a minimal impact on stock price movements.

Rule 12: A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites. B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites. C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks. D) The effect of an earnings surprise continues for an extended period of time.

The World of Contrarian Investing

Contrarian Investment Strategies

Rule 13: Favored stocks underperform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

There are many reasons why companies show outstanding earnings and sales growth for years and then slow down. Sometimes it is simply accounting gimmickry. Or a company might have a short-term competitive advantage, which the market, enraptured by the high profit margins and earnings, interprets as a long-term trend.

The more successful a company becomes, the more difficult it is to continue the record: Competition, governmental controls, and increasing market saturation all play a role in slowing growth. Too, a management team skilled at running a rapidly growing $50 or $100 million corporation may be lost at the $300 to $500 million sales level. Products and markets seemingly invulnerable to competition are suddenly inundated by it. Untouchable patents are circumvented by new discoveries. Costs cannot be controlled and prices cannot be raised, so profit margins are squeezed. Markets that appeared open for years of brisk growth become saturated. Political or economic events occur, such as an oil embargo or a sharp recession, totally beyond the control of even the most astute management, wreaking havoc in the marketplace. History constantly reminds us that in an uncertain world there is no visibility of prospects. Future earnings cannot then be predicted with accuracy.

[...] there are a number of contrarian strategies besides low P/E that work just fine. Low price-to-cash flow and low price-to-book value are both potent tools for beating the market.

Rule 14: Buy solid companies currently out of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

Boosting Portfolio Profits

The low P/E strategy is the oldest and best documented of all the contrarian strategies, and the one most used by market professionals today. Although there are many ways to calculate a P/E ratio, the most common is to take reported earnings for a company (before nonrecurring gains or losses) for the last 12 months and then divide them into price.

[...] our normal work ethic of constantly being busy to be successful is not useful but often counterproductive in investing.

Rule 15: Don't speculate on highly priced concept stocks to make above-average returns. The blue-chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman.

[...] one of the most important rewards of the "buy and hold" approach, as indicated with low P/E or the other low price-to-value strategies, is that lower transaction costs can result in a substantial increase in your capital over time.

Rule 16: Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price-to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.

Rule 17: Buy only contrarian stocks because of their superior performance characteristics.

Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more industries (if your assets are of sufficient size).

Rule 19: Buy medium- or large-sized stocks listed on the New York Stock Exchange, or only larger companies on Nasdaq or the American Stock Exchange.

A strong financial position will enable the company to sail unimpaired through periods of operating difficulties, which contrarian companies sometimes experience. Financial strength is also important in deciding whether a company's dividends can be maintained or increased.

Buying companies that show losses is considerably riskier than simply buying contrarian stocks. The investor must be very sure of the company's financial strength, and should use only a small portion of his portfolio for this purpose, while diversifying into a number of other issues to spread the risk.

Even though a strategy works most of the time and generates excellent returns, no strategy works consistently.

A New, Powerful Contrarian Approach

If trends and fashions exist in the marketplace as a whole, it is reasonable from a psychological perspective to expect that they exist within specific industries. Analyst research, expert opinion, current prospects, and a host of other variables should work on investor expectations almost identically within industries as in the overall market. The result again will be expectations set too high for favored stocks within an industry and too low for out-of-favor companies.

Rule 20: Buy the least expensive stocks within an industry, as determined by the four contrarian strategies [i.e. low P/E, low P/B, low P/CF, or high dividend yield], regardless of how high or low the general price of the industry group.

[...] keep in mind that the strategies are relative rather than absolute. This means that they won't help you decide when to get in or when to get out of stocks. Whether the market is high or low, you will receive no warning signals to sell in the first place or buy in the second.

Another important consideration is that when you buy foreign companies, you are taking an exchange rate risk that can greatly add to or detract from your total return.

The first rule of investing abroad is identical to the first rule of investing at home: buy 'em when they're cheap, not when everybody is on the bandwagon and the media hype is in full swing.

Regardless of the strategy you use, one of your most difficult decisions is when to sell.

Rule 21: Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.

Pick a sell point when you buy a stock. If it reaches that point, grit your teeth, brace yourself, and get rid of it. You probably will be unhappy because the issue often will go higher. But why be greedy? You've made a good gain, and that's what the game is all about.

Another question is how long should you hold a stock that has not worked out. [...] there are many partial answers to this problem, but I think 2.5 to 3 years is an adequate waiting period. (For a cyclical stock with a drop in earnings, this might be stretched to three-and-a-half years). If after that time the stock still disappoints, sell it.

Another important rule is to sell a stock immediately if the long-term fundamentals deteriorate significantly. No matter how painstaking the research, something can go wrong, worsening a company's or an industry's outlook dramatically. I'm not talking about a poor quarter or a temporary surprise that a stock will snap back from, but major changes that weaken a company's prospects. Under these conditions, I have found that taking your lumps immediately and moving on usually results in the smallest loss.

Knowing Your Market Odds

Rule 22: Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in a markedly different outcome.

Rule 23: Don't be influenced by the short-term record of a money manager, broker, analyst, or advisor, no matter how impressive; don't accept cursory economic or investment news without significant substantiation.

Rule 24: Don't rely solely on the "case rate". Take into account the "base rate" – the prior probabilities of profit or loss.

The greater the complexity and uncertainty in the investment situation, the less emphasis you should place on your current appraisal, and the more you should look to the rate of success or failure of similar situations in the past for guidance.

Rule 25: Don't be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the "case rate"). Long-term returns of stocks (the "base rate") are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

Rule 26: Don't expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.

Profiting from Investor Overreaction

You can frequently harness the powerful effects of a disappointing earnings surprise by buying GARP (Growth at a Reasonable Price) companies after they have been blasted. A good company trading at an above average P/E will often break sharply on bad news. The trick is to evaluate the earnings surprise. Is it something that will alter the company permanently? Or is it simply analysts' overoptimism or some other unpredictable but short-term negative event? Surprise need not be earnings related. Temporary loss of market share, industry price-cutting, a slowing of sales, and a host of other factors can also result in highly valued companies plummeting.

How should the smart investor react? Buy right after the plunge? Or wait till the dust clears? It's a tough call, but my advice would be to let the dust clear. Don't be a hero and charge into the initial panic. If you like a stock blown out by disappointing news, it pays to sit on the sidelines for a while. In all probability, you will get plenty of chances to buy it cheaper in the next 90 days.

In a dynamic environment there will be periods of excellent growth and profitability, which create the seeds of greater competition and lower growth some time in the future. On the other hand, for companies and industries undergoing difficulties, their lowered expansion, reduction of overhead, and belt tightening often bear the fruit of above-average growth once again.

Rule 27: The push toward an average rate of return is a fundamental principle of competitive markets.

Rule 28: It is far safer to project a continuation of the psychological reactions of investors than it is to project the visibility of the companies themselves.

Investor overreaction is one of the most powerful tools for making money in markets.

Investing in the 21st Century

Crisis Investing

A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest. In a crisis or panic, the normal guidelines of value disappear. People no longer examine what a stock is worth; instead they are fixated by prices cascading ever lower. The falling prices are reinforced by expert and peer opinion that things must get worse.

Rule 29: Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don't sell.

Rule 30: In a crisis, carefully analyze the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny.

The psychological barriers against following contrarian strategies in times of crisis are high. Panic doesn't just affect sellers, it often keeps even experienced buyers away.

Rule 31: A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren't getting a clinker. B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

An Investment for All Seasons

Clearly, the conventional wisdom that fixed-income investments are safe is unsound. If you are saving to buy a house or a car or have another use for funds within a few years, then T-bills, money market funds, or short-term bonds are certainly reasonable. In a short period stocks are simply too unpredictable to depend on. However, once you push the window beyond four or five years, you should keep the large proportion of your assets in stocks or another investment, such as real estate, where there is a long-term record of outperforming both inflation and taxes.

What Is Risk?

Rule 32: Volatility is not risk. Avoid investment advice based on volatility.

The goal of investing is to protect and increase your portfolio in inflation-adjusted, and (where appropriate) tax-adjusted dollars over time.

Small Stocks, Nasdaq, and Other Market Pitfalls

Rule 33: Small-cap investing: Buy companies that are strong financially (normally no more than 60% debt in the capital structure for a manufacturing firm).

Rule 34: Small-cap investing: Buy companies with increasing and well-protected dividends that also provide an above-market yield.

Rule 35: Small-cap investing: Pick companies with above-average earnings growth rates.

Rule 36: Small-cap investing: Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one.

Rule 37: Small-cap investing: Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.

Rule 38: Small-company trading (e.g. Nasdaq): Don't trade thin issues with large spreads unless you are almost certain you have a big winner.

Rule 39: When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large your total cost will be.

Rule 40: Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.

Psychology and Markets

The Zany World of Rationality

The rational man, like the Loch Ness monster, is sighted often but photographed rarely. Everybody claims to invest rationally, but point a camera at them when speculative opportunities arise, and something fogs the film. The developed photo fails to show any sign of that rational being beloved by economic theorists.

Investors continually overestimate the outlook for some investments and underestimate the prospects of others. Often the euphoria or pessimism goes to extremes.

Rule 41: A given in markets is that perceptions change rapidly.

Four general principles seem to emerge from a study of financial speculations. First, an irresistible image of instant wealth is presented, forming a crowd around it. Second, a social reality is created. Opinions converge and become "facts". Experts become cheerleaders approving events and exhorting the crowd onward. Overconfidence dominates, standards and experience of many years are forgotten. Third, the image in the Le Bon magic lantern suddenly changes, and anxiety replaces overconfidence. The distended bubble breaks and panic ensues. Fourth, we do not, as investors, learn from our mistakes – things really do seem different each time, although they are really pretty much the same.

Beyond Efficient Markets

[...] your financial progress cannot be secured by embracing the fashion of the moment, whether it is a new stockbroker, a "hot" mutual fund, or the latest wrinkle in market theory. It is in remembering what works – and perhaps more important, what doesn't work – that guidance can be found and a strategy adopted that will serve you well over the long haul.