Terms Of The Trade: Contrarian Investing

Even if they aren’t familiar with the source, most investors at some time or another have heard some variation of the investing quote attributed to 18th century nobleman Baron Rothschild:

“Buy when there’s blood in the streets, even if the blood is your own.”

This quote is the creed of every contrarian investor. Contrarian investing is a style of investing that involves buying stocks when others are selling and selling stocks when others are buying. In contrast to momentum traders, who try to ride the prevailing winds of the market, contrarian investors look for opportunities to capitalize on market overreaction and long-term cyclicality.

Perhaps the most famous contrarian investor is Warren Buffett. Buffett has earned a reputation (and a few billion dollars) as a value investor. Buffett buys stocks when they seem to be a good value, regardless of what the rest of the market thinks of them.

In fact, when it comes to the most popular stocks in the market, Buffett once said, “You pay a very high price in the stock market for a cheery consensus.”

Related Link: BMO Capital Markets Offers Up A Host Of Contrarian Stock Ideas

The psychology behind contrarian investing is that market sentiment regarding the most popular and least popular stocks tends to temporarily push share prices beyond realistic valuations. Contrarian investors look for opportunities to step in and invest when market sentiment extremes have created disconnects between value and share price.

For example, Buffett’s Berkshire Hathaway Inc. currently owns about $1.6 billion of General Motors Company GM stock. Despite the fact that the stock is down more than 7 percent in the past two years in the midst of a raging bull market, Buffett sees value in GM’s minuscule forward PE ratio of 5.5.

Perhaps the best argument a contrarian investor can make is this one: If you expect to outperform the market, how will you do it copying what the rest of the market does? Contrarian investors are constantly looking for times when the rest of the market gets it wrong, and they aren’t afraid to go against the flow.