Stock market investors can often act with herd mentality. When prices are rising, investors begin buying more aggressively for “fear of missing out (FOMO)”. When stock prices are falling, investors sell as they feel there is no bottom. Contrarian investing, on the other hand, means holding a viewpoint that goes against that general consensus or better known as going against the grain.
Warren Buffett is one of, if not the, most famous contrarian investors. He coined the phrase “be fearful when others are greedy, and greedy when others are fearful” which encapsulates the philosophy of contrarian investing. A common method to contrarian investing is capitalizing on companies that are temporarily out of favor to buy when others are fearful in the hopes of outperforming when rationality returns. However, it is important to understand if this pessimism is temporary or if it is structural and permanent. Also, contrarian investing doesn’t always mean “cheap stocks”. Sometimes, stocks with relatively higher valuations can also be out of favor. It is more important that there is a reason or catalyst for an out-of-favor stock to rebound in the future.
A recent example of contrarian investing is Costco Wholesale Corp (Ticker: COST). After the initial shock from the COVID-19 pandemic in 2020, the stock price began to underperform the broader market (S&P 500 Index) and was considered an “out of favor” company. In March of 2021, the stock began to outperform the broader market and an investor who stepped in during that time would have reaped the reward of holding Costco. This can be seen in the chart below2.
A contrarian investor must recognize the sentiment in the stock and follow a set of principles or processes to understand the fundamental value. The idea is not to determine if the stock has bottomed but to understand if there is a value in purchasing now to accrue the benefits of an expected rebound.
This type of investing is not without risk. A company whose stock price that has fallen dramatically does not necessarily make it a good opportunity. There are several possibilities that could cause a continuation in price declines, including:
- Investing in a “value trap” where valuations get cheaper as their business remains impaired.
- Undervalued securities continue to fall further in price (“cheap get cheaper”)
- Price normalization in the security takes longer than expected
Lastly, being a contrarian investor also requires selling once that value has been realized. If the price of the stock price has risen to levels that no longer reflect as out of favor, the contrarian investor would sell that position and look for the next opportunity.
Currently, the broader market has experienced a significant correction with many stocks in a bear market (more than a 20% price decline from the all-time high). These price declines have created a number of attractive opportunities for the contrarian investor. Gradient Investments has the Contrarian Choice portfolio that seeks out the companies that are out of favor and has a high concentration in those companies. In order to make the most of these circumstances, the Investment Committee views this portfolio as advantageous and has recently introduced it into the Tilt Series models.