7 Rules Every Contrarian Investor Must Follow

“The time to buy is when there’s blood in the streets.” – Baron Rothschild

Contrarian investors attempt to profit by exploiting opportunities where consensus opinion appears to be wrong. For example, widespread market pessimism can drive a stock price below its intrinsic value, leading a contrarian investor to buy the stock and sell for a profit after the stock reaches fair value. The risk is that crowds can defy logic for extended periods of time, but patience can pay off handsomely.

On the whole, contrarians appear to outperform the market when accounting for risk. A November 2009 study titled Uncommon Value: The Investment Performance of Contrarian Funds found that contrarian funds outperformed by more than 2.6% per year, both before and after fund expenses, holding stocks with much greater improvement of profitability compared to so-called herding funds.

In this article, we’ll take a look at seven rules that every contrarian investor should follow to enhance the odds of making successful trades.

#1. Mind the Noise

From the talking heads on CNBC or Bloomberg to catchy headlines in the WSJ or IBD, the markets’ sentiment is swayed by a relatively limited number of sources.

Contrarian investors should stick to the numbers and tune out the television or newspaper when analyzing investments. While headlines certainly can impact stock price, they often have very little impact on a company’s true value, which is ultimately the price that contrarian investors are looking to beat.

Former managing director at Drexel Burnham and current “Doom & Gloom” specialist, Dr. Marc Faber was famously quoted as saying “Follow the course opposite to custom and you will almost always be right.” Basically, the good doctor is saying if the talking heads are on CNBC saying buy it – don’t.

#2: Have Your Own Plan and Stick to It

Sun Tzu once said, “Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.”

Much of contrarian investing comes down to actual stock or sector analysis. That means digging into numbers and firm’s corporate filings. From price-to-book ratios, historical earnings metrics, price-to-sales etc. All must be used to determine if a stock or sector is truly a bargain. That analysis is key to finding unloved and forgotten about investments, while everyone else is rushing towards the next big thing. The only way to gain foresight and conviction to buy when everyone else is selling is by keeping up with your own analysis and developing the discipline to follow through with your ideas.

By focusing on stocks are actually worth via real metrics, you can make sure that gaining real values rather than just the flavor of the month picks.

Contrarian investors must carefully plan trades and rely on those plans, since the rest of the market has a different plan. In order to do this, investors must also have the foresight and conviction to buy when everyone else is selling, while maintaining their due diligence throughout the trade to deal with any problems that arise.

#3: Don’t Ask Your Barber for Stock Picks

The Dunning-Kruger effect, first tested in 1999 at Cornell University, found that people without a set of skills tend to overestimate their abilities.

Contrarian investors should realize that there are no shortcuts to uncovering great investment ideas, which means that they must rely on their own wits to identify and execute on their own ideas, especially when they’re not popular. The same goes for following through with ideas when many people may be advising otherwise.

#4: Always Be Skeptical

A key hallmark of market bubbles is a lack of skepticism, particularly within the popular press, as occurred with the tech bubble in 1999 and 2000.

Contrarian investors must be inherently inquisitive by nature, training themselves to always ask challenging questions that media pundits and the status quo are ignoring. By doing these things, investors can mold themselves into contrarians in the truest sense and avoid looking at the market through rose-colored glasses.

Are the concerns with coal legislation really detrimental to stocks in the sector? Why exactly are Japanese bonds so hated right now? You’ll never know unless you take the time to at least look at all of the opinions out there. Just don’t let them go to your head and sway your analysis if it’s truly sound.

#5: Be Patient

The Iranian Poet Saadi once said, “Have patience; all things are difficult before they become easy,” which couldn’t be any truer for contrarian investors.

Value investing is often called time arbitrage. That’s because it can take years before an asset class or stock gets Wall Street’s full attention. You need to wait until the market realizes just how valuable an asset class or stock is that you have uncovered. For a true contrarian investor to be successful, they must be patient. Slow and steady wins the race here.

Contrarian investment ideas often take a lot of time to unfold given that they are going against the conventional market wisdom. For example, it took Bill Ackman several months before his bet against the ratings agency MBIA was validated by the market, making him billions when others were losing their shirts.

Another example lies in pipeline Master Limited Partnerships (MLPs), which are all the rage with investors during low rate environments. However, the asset class has been around since the 1980s with many of the modern MLPs forming in the late 1990’. Many just sat there as investors favored faster moving tech stocks. Twenty years later and share prices for the major MLPs have all but exploded upwards.

#6: Use Panic to Your Advantage

Declining stock chart

As Baron Rothschild said in the quote that began this article, the best opportunities to buy are when everyone else is desperate to sell.

Contrarian investors look for opportunities when the market is being irrational, which can consist of irrational exuberance or irrational selling. When the market is panicking, contrarian investors should diligently do their research and identify the point at which the market has significantly overreacted.

A political strife here, a natural disaster there, a missed earnings guidance number – all of these can send a market or stock price downwards into the basement. Wall Street has a very itchy trigger finger and will often do a knee-jerk reaction to a bit of bad news. However, not all bad news is as dire as it may seem in a headline or blog post. An informal Security & Exchange Commission (SEC) Inquiry is not the same thing as an SEC action or sanction. Just because a firm missed analyst estimates doesn’t mean it wasn’t profitable or making money.

Yet, the market will often see all these events as the same and sell off on the news.

That’s where a contrarian can truly shine. By sifting through the real events from the non-ones, they can score deals on stocks and snag other assets as others sell with abandon. During the panic caused by the Great Depression, famous value investor John Templeton took $10,000 and bought shares in every small-cap stock trading on a major exchange for $1 or less. While some of those didn’t make it, the vast majority were just fine and rose higher. Those stocks became the foundation of Templeton’s vast wealth.

#7: Focus on Out of Favor Securities

The best opportunities aren’t those that nobody sees, they are those that everybody sees but nobody cares about.

Contrarian investing is all about going against the crowd rather than with it, which means that out-of-favor securities should be the focus. These securities can include those that have been downgraded by analysts, missed earnings, or those operating in out-of-favor sectors, although that shouldn’t be an exclusive basis for selection.

By combing through the most hated sectors/stocks and using real analysis, you can uncover great long term bargains and score some real hefty returns as these firms revert to the mean. Look at the rail roads. A decade ago they were dead money. Today, fracking and fuel efficiency has brought them screaming back.

The Bottom Line

Contrarians have consistently outperformed the overall market over time on the whole, suggesting that there’s merit to looking at what others dismiss. To do this, these investors pride themselves in finding opportunities where the rest of the market has moved on and profiting from turnarounds. Contrarian investors should keep the aforementioned seven tips in mind when trading in order to enhance their risk-adjusted returns.