Against The Grain - Contrarian Investing
Most investment analysis involves some degree of fundamental research, the study of individual companies, sectors or markets, and the economic forces driving them higher or lower. Other strategies involve market timing, trying to discern where the markets are going and acting accordingly, or technical analysis, studying price and volume changes in order to make near and longer term judgments on individual company stocks or the broader markets.
You often hear investors say, “Don’t follow the crowd,” but they’ll also say “The trend is your friend.” We know there is safety, or at least comfort, in numbers. However, the discipline known as contrarian investing, which builds a sophisticated philosophy and strategy out of going against the grain, has considerable resonance for many investors.
Along with many other newly minted stockbrokers working at Rauscher Pierce Refsnes in the 1980’s, one of our major influences was David Dreman, former director of research for the firm and author of “The New Contrarian Investment Strategy.” Dreman did extensive study of investor behavior, stock performance, and the relative value of analysis and economic predictions. In an era of high flyers, his innovative approach involved selecting stocks on the basis of low P/Es, or price earnings ratios. These were relatively unpopular companies, those for which the markets gave little value to future earnings. When screened for size and financial stability, these out-of- favor companies as a group handily outperformed the higher P/E stocks of companies with greater support and expectations. Contrarian investing had a voice.
Classic “value investing,” an approach developed and refined by investment giant Benjamin Graham, involves buying stocks at less than fair value and holding them until they reach their fair, or intrinsic value. This strategy has strong contrarian elements; typically, for a stock’s price to sink low enough to make Mr. Graham’s screen, the company must be out of favor, overlooked, and pummeled by bad news.
Then there are the “Dogs of the Dow.” This contrarian discipline involves buying the ten highest yielding stocks of the Dow thirty, holding them, and replacing them at predetermined intervals as other Dow companies that fall into this high yield list. Dow stocks, which are generally larger, more stable companies, are more inclined to protect their dividends than the average stock. So, these high yielding stocks are usually there because they have become unpopular, and their prices have fallen while their dividend amounts have remained the same.
There are other useful contrarian indicators that relate to the entire market. Volatility indexes, the VIX for example, measure changes in options prices, and can indicate the level of bullishness or bearishness among options buyers and sellers. A high index reading indicates negative sentiment, while a low number indicates positive investor expectations. As you might have guessed, more often than not the negative sentiment of these investors proves, perversely, to be an indication of better things to come.
The AAII, or American Association of Individual Investors, has for many years published a survey of their members, which tend to be a well educated, affluent, and self directed group. The bullish sentiment in this group slumped to a low of 12% in the fall of 1990, when the Dow was at 2,500, right before the beginning of the historic technology bull market. The survey’s most optimistic outlook for the future peaked in January 2000, at the height of the dot.com boom. The Dow was then at 11,300, and headed down.
Finally there are magazine covers, which have gained a reputation as contrarian indicators in their own right. Investors may recall the famous cover of Business Week magazine on August 13, 1979, titled, “The Death of Equities.” The Dow hit 875 that day; scarcely eight years later it had more than tripled. At the Bedminster Group offices we keep a framed cover from “The New Yorker” dated October 20, 2008; A black background highlights a red cloaked skeleton, a stock chart with bloody arrows plunging downward, and a crowd of brokers below crying bloody tears. The Dow was at 9,265 that day, and would fall as low as 6,600 by March 2009. By then, more than 70% of all investors surveyed were extremely pessimistic about future stock returns. The stock market began to climb a wall of worry that month, and so far, hasn’t looked back.
Steven Weber, Registered investment advisor, and Gigi Harris, Dir., Client Communications, are members of the Bedminster Group, a fee-only advisor providing investment and financial counsel to clients in the Low Country since 1997.