This article on deep value contrarian investing was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by Ian Muttoo, edited by Broken Leg Investing.
Have you ever wondered what it is about deep value investing that makes it contrarian? Or, why deep value investing strategies even make sense from a contrarian perspective?
While similarities exist between deep value and contrarian strategies, there are intricate differences between them—and both will make you a better investor!
Seth Klarman, in his book Margin of Safety, addresses the relationship between the two styles (contrarian and deep value), and what it is that makes their combination—deep value contrarian investing— such a winning strategy.
What Makes a Deep Value Contrarian Investing Also Contrarian?
Before discussing why a deep value contrarian investing strategy works, we first need to pinpoint the relationship between the two factors.
Klarman explains it best:
“Value investing by its very nature is contrarian. Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor. Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked.If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price may fall well beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued.”
So, on the one hand, contrarian investing strategies represent those strategies that seek to go against popular opinion and those investments that are “in favor.” Similarly (but not identically), deep value strategies seek investments that are undervalued and have not been overbought to the point that they are either fairly or overvalued.
In this way, consider value investing as a subset of contrarian investing. This is because the volume of those securities that are bought and sold on the market directly decide the prices of publicly traded securities. Therefore, if everyone sees Apple as a great investment, many will buy its stock—it is now “in favor.” As a result of this buying, Apple’s price will be bid up, making it less and less undervalued—and more and more overvalued. The opposite, of course, is also true, which is what makes a deep value investing strategy also a deep value contrarian investing strategy.
Why Is Every Investor Not a Contrarian Investor?
Don’t blame a prudent and rational thinker at this point for asking why everyone is not a believer in deep value contrarian investing. The sarcastic answer to this is that if everyone were a contrarian, then nobody would be a contrarian. The true answer, however, is that it is extremely difficult to be a contrarian investor!
From both sociological and psychological perspectives, it is extremely difficult for us humans to zig while everyone else zags.
Again, Klarman says it best:
“Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.”
According to Klarman, our tendency to drop an idea that does not pay off immediately means that most people refuse to stick with a deep value contrarian investing strategy for the long haul. Coupling this need for immediate gratification with the fact that Wall Street is extremely quick to judge someone’s performance leaves no wonder why few investors pursue such a strategy.
A select few investors, though they all approached the style from different perspectives, have found great success by using a deep value contrarian investing strategy. Klarman, David Dreman, Warren Buffett, and Benjamin Graham are just a handful of examples of investors that all took advantage of such deep value contrarian investing strategies.
While all of the above is true, investors should be vigilant when it comes to the application of contrarian strategies. As with any investment strategy, it is important to note that investors should always be aware of the tripwires associated with deep value contrarian investing strategies.
“Holding a contrary opinion is not always useful to investors, however. When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor. When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians.”
Klarman points out that unless there is some form of catalyst that causes or speeds up the return of the share price to its intrinsic/fair/liquidation/net net value (whichever is relevant), it is possible that the share price may remain undervalued permanently.
Therefore, investors must be careful that specific active market forces caused the undervaluation rather than long-term inactivity and/or apathy.
While contrarian strategies come in many forms, a deep value strategy is certainly one of them. Because of their very nature, contrarian investment strategies tend to produce superior long-term returns. Because these strategies target unpopular stocks, such investments tend to be relatively undervalued compared to securities that are “in favor.”
However, while contrarian strategies do work in general, investors must be careful not to assume that all eggs fall into the same basket. While any given contrary idea may seem viable, unless active market forces caused its viability, the strategy may never realise its full potential.
Therefore, while deep value contrarian investing strategies can indeed provide powerful earnings potential, we must remain acutely aware that any single specific deep value contrarian investing idea might not have the practical means to achieve the necessary returns. We must learn to identify when sheep are behaving like sheep, and when they are simply asleep in the field.
Enter your email address below because we’ll send you inside info on the best performing deep value investing strategies today PLUS a free copy of The Broken Leg Investment Letter.