This article on contrarian investing vs deep value was written by Colin Richardson. Colin is a private investor based in Alberta, Canada. He focuses on applying a quantitative strategy to eliminate behavioral biases in his personal account. Article image (Creative Commons) by qimono, edited by The Broken Leg.
At The Broken Leg, we often use the terms contrarian investing and deep value. This is because — we believe — they represent the most beneficial strategies for an individual investor. When I was first introduced to the strategies, I was confused and full of questions. What are contrarian and deep value investing? Is there a difference between the two? Should I be contrarian, or should I be deep value? Is it possible to be both?
My journey started at a one-day finance seminar along with 6,000 other attendees. A self-proclaimed value investing guru strode on stage and pitched the audience the idea of safe, risk-free investing. He affirmed that value investing can work in any market and give an individual investor an advantage over the pros. Although these descriptors are true, the speaker failed to mention two key components of value investing.
First, I was not informed that value investors are often referred to as being contrarian. Although — at the time — I wouldn’t have even known what the word contrarian meant, it would have been nice to know that majority of the investing world does not follow the strategy. I wasn’t even informed that the majority of experts doesn’t even believe in the strategy. I learned that Warren Buffett was a value investor, and I should be too.
The second piece of misinformation came when the speaker described how to pick value stocks. At the seminar, I learned to identify moats, assess management, and generate a growth rate. This is a great technique if you either have Buffett’s skills and experience or a crystal ball to see the future. Unfortunately, I have neither, yet I was led to believe this process is simple and straightforward.
I went home that evening convinced I had a high chance of being the next Buffett. I even went as far as pitching to my best friend the opportunity to be my Charlie Munger. Little did I know that the important details missing from the speaker’s presentation were about to hit me square in the face.
The Discovery Of Contrarian Investing
Still excited about my journey ahead, I shared with a co-worker the value investing principles I had learned. I didn’t know at the time, but she had previously graduated with a finance degree and worked as a financial advisor for a major bank. I was soon made aware of the efficient market hypothesis and the inability for anyone to beat the market. I didn’t agree — the idea of a stock selling for a different price then its value just seemed to make sense to me. After doing some more research, I realized my perspective is not wrong but considered contrarian.
Contrarian investing dates back to the 18th century, when nobleman Baron Rothschild is quoted saying, “The time to buy is when there's blood in the streets.” Rothschild tells us that the most ideal time for an investor to purchase stocks is when everyone else has been beaten by the market and become fearful of the future.
There are many contrarian investing approaches, including value investing. Being contrarian just means to follow an investment strategy that is not generally accepted. If your approach was to only buy shares in American large-cap companies that start with the letter C, the large majority of investors would consider you both contrarian and crazy. Their opinion really wouldn't matter though, because this strategy has actually been proven to outperform the S&P 500 for the last 56 years. The same likely holds true for all contrarian strategies. This is because in order to beat the market, you must be different than the market.
We should not talk about contrarian investing without mentioning David Dreman. The well-known Canadian investor is a huge advocate for contrarian investing. He has written four books on the approach and has used it to beat the market for many years.
One of Dreman’s favourite techniques is to buy companies with low price/earnings multiples. Research shows that these companies are overlooked and unpopular but have a high chance of outperforming in the future. As Buffett once said, “Be fearful when others are greedy, and be greedy when others are fearful.”
The Need To Dig Deeper
The conversation with my coworker, did not deter me from value investing. I sat at my computer with a a discounted cash flow spreadsheet open, ready to calculate some intrinsic values. The formula worked fine until the spreadsheet demanded a future growth rate. As I began to estimate a full range of growth rates, I soon realized just how important the number was to the intrinsic value. After many weeks of trying to develop a technique for forecasting growth, I was left frustrated, confused, and discouraged. Sitting in front of my computer, I realized I was not ready to just be a value investor — I needed to dig deeper.
When Buffett was younger and less experienced, he followed a technique referred to as deep value. Simply put, deep value investors use conservative valuation techniques and only purchase shares when the price is less than their calculated value. What I soon learned was that the majority of investors — including myself — will be more successful giving up regular value investing and searching for deep value.
Benjamin Graham, author of The Intelligent Investor, was the founding father of deep value investing. Graham was an advocate for purchasing stocks for less than net current asset value. This means that even if the company were to liquidate and pay off all liabilities, shareholders would still be paid out more than what they paid originally. Other deep valuation methods include book value, dividend value, private market value, and the acquirer’s multiple. Although these methods only identify troubled companies, if purchased at a great price, you’ll easily realize a profit.
Deep value investing is even more contrarian than regular value investing. However, this doesn’t mean it’s more risky. Some would even argue deep value investing is less risky and provides a better chance of beating the market. The conservative valuations give investors the opportunity to make a profit from the moment their order goes through.
The Key Lessons
If I could go back in time, I would teach myself a few key lessons. First, while all deep value is contrarian, not all contrarian is deep value. Second, being contrarian is a good step towards success in the stock market, but finding deep value is even better. Third, don’t waste time attempting to predict the future — focus valuations on financial statements.
Shortly after learning these lessons the hard way, I found Net Net Hunter and The Broken Leg. The resources provided throughout both sites took my stock portfolio to another level. I became more confident in contrarian investing and analysing deep value stocks. Now, my most successful stock picks have been deep value and were overlooked by even the best investors.
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