What it Means to Be Contrarian

08/12/2011 7:30 am EST

Focus: MARKETS

Some very successful investors are described as contrarians, but it’s dangerous to think being contrary is the same as being contrarian, says Esther Pak of Morningstar.com.

Question: I know that some of the most famous investors have been contrarians. But what exactly does that mean, and how do I implement the approach in my portfolio?

Answer: As harrowing as the recent market sell-off has been, widespread pessimism surrounding the economy has been creating opportunities for value-conscious investors.

For much of the year, Morningstar’s equity analysts had considered stocks in their coverage universe to be slightly overvalued. But as a result of the harsh sell-off in the last week, the average stock in our coverage universe is now trading at a more than a 10% discount to fair value, and our analysts think high-quality names such as Abbott Laboratories (ABT) and ExxonMobil (XOM) appear to be quite cheap.

Picking up mispriced stocks is a contrarian investor’s objective, and such opportunities invariably surface when the market is looking particularly weak. Being willing to purchase out-of-favor stocks, then selling them after their share prices have recovered, can obviously lead to above-average gains.

On the other hand, avoiding companies where there is excessive optimism about a stock or sector can help the contrarian avoid market bubbles like the late 1990s technology heyday and the Nifty Fifty era of the 1970s.

As lucrative as a contrarian strategy might seem, executing isn’t exactly straightforward. Here are three pointers for going against the crowd without getting trampled.

Delegate to a Good Contrarian Manager
If you’re attracted to a contrarian strategy but aren’t comfortable betting on individual troubled companies, buying a mutual fund whose manager employs a contrarian approach is the way to go. Such managers look for securities that are (sometimes deeply) out of favor, but they can take a diversified tack and might be backed by extensive research teams and resources that are not available to the individual investor.

Notable contrarian managers on the domestic-equity front include Guy Pope and David Williams of Columbia Contrarian Core (LCCAX). And renowned contrarian Bruce Berkowitz of Fairholme (FAIRX) has been making headlines with his latest contrarian move, piling into the troubled financials sector.

Berkowitz’s high-stakes bet that distressed financials will rebound has led the fund to steep losses during the past year. But as Morningstar analyst Kevin McDevitt notes, banks are Berkowitz’ specialty, and his previous big bets have almost always panned out in the long run.

Investors seeking a contrarian bent in their foreign-equity exposure will find a lot to like in Oakmark International (OAKIX), lead-managed by Morningstar International Stock Fund Manager of the Decade David Herro. These days, Herro is avoiding the fertile stomping ground of emerging markets in favor of unloved European banks and dilapidated Japanese companies.

Keep in mind that even though most of these managers boast impressive long-term track records, it is not uncommon for their funds to suffer severe short-term lags. So if you want to invest in a fund that has big stakes in the unloved, make sure you have a long time horizon and the discipline to hang on through the inevitable rough patches.

NEXT: Mind the Downside

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Mind the Downside
If you decide to invest in individual stocks rather than investing in a mutual fund, remember that badly beaten-down securities are usually down for a reason, and there’s a possibility other market participants know something you don’t.

Thus, investors buying individual stocks should not forsake the long-heralded benefits of diversification when employing a contrarian tack. Dollar-cost averaging and diversifying across multiple sectors can help mitigate security-specific risk.

Contrarian stock investors should also take pains to discern whether a company’s stock is a true value or a so-called value trap. Both value stocks and value traps might look undervalued based on standard metrics such as price-to-earnings ratios or price-to-book value per share measures.

But value traps are marked by inferior fundamentals. Investors must determine whether a company is experiencing a temporary setback or whether their buy-in will be the start of a death spiral.

Ask yourself some key questions that will help you distinguish between a bargain stock and a value trap.

  • Does the business have strong fundamentals—that is, does the company have a solid balance sheet with little or no debt, and also generate plenty of free cash flow?
  • Is its brand intact?
  • Is its market position sustainable and growing?

McDonald’s (MCD) is a good example of a contrarian play that worked out well because its fundamentals were intact. A decade ago, the company was undergoing restructuring in an effort to resuscitate its stagnant business. Wall Street, at the time, had written off the firm as good as dead.

But even then, Morningstar analysts were optimistic about the firm’s long-term prospects. For starters, McDonald’s had a rock-solid balance sheet, and its annual free cash flow was strong.

Wall Street eventually recognized the firm’s solid and improving fundamentals: As of the end of July 2011, McDonald’s stock was priced at $86.48—up from its nadir of $16.08 at the end of the 2002 calendar year.

Implement a Contrarian-Lite Approach
Finally, sticking to a disciplined, regular rebalancing program is yet another way to be a contrarian without taking on the risk of buying a stock that has fallen but can’t get up.

Rebalancing is an inherently contrarian practice because in the case of an equity market decline, this would mean buying more stocks to raise your stock allocation to your original target, or in the case of market increases, selling stocks to reduce the stock allocation back to the target.

Rebalancing is easy to grasp in theory, but difficult in practice. Indeed, many investors actually do the opposite—buy stocks at market highs and sell stocks at market lows.

As a result, even if the S&P 500 index has made gains, such investors only manage to capture a slice of it. This performance gap would be mitigated by practicing disciplined portfolio management in the form of rebalancing.

Investors can also rebalance among different investment styles; for example, a contrarian might have whittled away his small-cap exposure recently and moved money into large-cap stocks.

Read more from Morningstar.com here…

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