What is Contrarian Investing?

Investing in financial markets is becoming an increasingly popular way to realize financial objectives. Many investors invest to achieve their retirement goals. But how can an individual achieve returns that significantly exceed the benchmark? An investor needs to think outside the box to beat the benchmark, and contrarian investing strategies are a way to create huge wealth. 

In today’s blog, we will discuss contrarian investing, different approaches used to do contrarian investing, its implementation challenges, and real-world examples.

What is Contrarian Investing?

Contrarian investing is a strategy where investors intentionally go against the prevailing market trends. Investors who follow a contrarian investing strategy are known as contrarians. They follow the basic rule of buying when others are selling and selling when others are buying.

Contrarian Investor aims to capitalize on mispriced assets by deliberately going against the latest market trends. This approach requires independent thinking, careful analysis, confidence, and a willingness to withstand sudden market fluctuations. 

Contrarian investing is an active strategy aiming to outperform the market. Contrarian investing consists mostly of long-term investment strategies focusing on overlooked and mispriced opportunities.

Different Approaches Used to Do Contrarian Investing

Investors follow different processes mentioned below to do contrarian investing: 

• Market Sentiment Analysis: Investors analyze the market sentiment through news, social media, economic data releases, etc, to gain valuable insights. By gauging the prevailing sentiment, traders can identify potential turning points in the market and make informed decisions based on sentiment shifts.
• Value Investing Approach: Contrarian investors constantly search for undervalued assets that the market has overlooked. Investors conduct a detailed fundamental analysis of the asset and gauge its potential for long-term capital appreciation.
• Distressed Investing: Contrarian investors actively search for companies facing distress, restructuring, or bankruptcy because most market participants do not favor such assets. By carefully analyzing the underlying value and potential recovery, investors try to acquire them at low valuations. Investors make substantial gains once the company’s profitability increases.
• Event-Based Trading: It involves capitalizing on market reactions to specific events, such as government policy change, central bank policy announcements, budget, regulatory announcements, and company earnings releases. Contrarian traders predict market reactions to these events and position themselves accordingly to profit from market fluctuations.
• Pattern Recognition: Using chart patterns and technical analysis to identify potential trend reversals can be a powerful tool for contrarian traders. Even the put-call ratio can be used for contrarian investing. These patterns tell about potential shifts in market sentiments, providing opportunities for contrarian trades.

Challenges of Contrarian Investing

Limitations of contrarian investing are as follows:

• Time-consuming: It needs lots of research to go against the prevailing trend, so it’s a time-consuming practice.
• Difficult to Time: It’s extremely challenging to accurately time the trades as identifying the exact reversal points is difficult.
• Patience and long-term focus: Patience is required as the focus is to realize gains from mispriced assets that others haven’t identified at the right time. Investors need to create positions before others identify the opportunity and wait until the majority of the market participants identify it. Once the majority identifies it, the asset’s market price moves in a favorable direction. Therefore, a longer time frame is required to realize substantial gains.
• Potential for an extended period of underperformance: If market sentiment continuously goes against your view, it can result in portfolio underperformance in the short term.
• Knowledge of the market and methods is required: One should be well versed in different analysis methods, such as fundamental analysis, technical analysis, etc., to identify mispriced assets ahead of time with confidence. 
• Limited Liquidity: Contrarian investors also invest in assets that are not widely traded, making it difficult to create and exit the investment position.
• Lack of information or limited information: Sometimes, contrarian investors may have limited information or wrong information about the asset, which can lead to incorrect analysis and wrong investment decisions.

Examples of Contrarian Investing

John Paulson and the Subprime Mortgage Crisis (2007-2008):

• Case:  When most investors believed the housing market prices would continue to rise, Paulson predicted against popular belief and took a contrarian position. 
• Strategy: Paulson used credit default swaps (CDS) to bet that mortgage-backed securities would collapse. CDS is a tool through which credit risk is transferred, similar to insurance, where the buyer pays premiums for protection against risk. Hence, the buyer of the CDS gets a set amount if the underlying assets default, go bankrupt, or face credit ratings downgrade.
• Outcome: When the housing market crashed, Paulson made a fortune of USD 4 billion alone while his firm earned a total of USD 15 billion, which earned him the tag of “a man who made one of the biggest fortunes in Wall Street history.”

Warren Buffett and Goldman Sachs (2008):

• Case: At the peak of the Global Financial crisis in 2008, when all the banks in the US were facing a liquidity crisis, Buffett supported Goldman Sachs soon after the fall of the Lehman Brothers.
• Strategy: Warren Buffett’s Berkshire Hathaway invested USD 5 billion of preferred stock in Goldman Sachs to strengthen the firm’s capitalization and liquidity in turbulent times.
• Outcome: The preferred stock was redeemed in 2011, which generated a profit of USD 3.7 billion for Berkshire Hathaway, which is approximately 74% of the investment.

Warren Buffett and Bank of America (2011):

• Case: During the debt-ceiling crisis of 2011, Bank of America’s stocks lost more than half of its value and fell from $14 to $5 over a year.
• Strategy: Buffett invested $5 billion in Bank of America through preferred shares and warrants to buy 700 million common stock at a price of $7.14 per share. The preferred shares were redeemable at a 5% premium and paid a 5% annual dividend.
• Outcome: Bank of America’s stock prices increased over the next few years, and Berkshire Hathaway more than tripled its investment without considering the dividend income.

George Soros and the British Pound (1992):

• Case: The British government was trying to keep the pound within the European Exchange Rate Mechanism (ERM) despite economic indicators suggesting it was overvalued.
• Strategy: Soros created a short position against the pound, betting on its devaluation.
• Outcome: On 16 September 1992, also known as the Black Wednesday, the pound crashed, and Soros made an estimated USD 1 billion profit, while the British government had to withdraw the pound from the ERM.

Historical Returns of Contrarian Investing

The return an investor can earn using the contrarian investing approach is enormous, but these abnormal returns require lots of time, effort, knowledge, and patience. However, it’s not a suitable strategy for the short term as a big risk of uncertainty is involved. 

Historical returns of contrarian investing are beyond imagination. Warren Buffet, Michael Burry, George Soros, John Paulson, etc., earned a fortune through contrarian investing strategy, but they all took calculated risks based on their knowledge and analysis.

Conclusion

In summary, while contrarian investing can be lucrative, at the same time, it’s time-consuming, and it requires a deep understanding of market fundamentals, the right timing, confidence, patience, and the ability to withstand potential losses. Investors should carefully consider these factors and should combine contrarian strategies with other investment approaches and tools to achieve balanced and long-term returns.

The contrarian investing approach requires an in-depth understanding of the financial markets. Therefore, it is important to consult a financial advisor before investing.

Frequently Asked Questions (FAQs)