Contrarian Investing: A Closer Look


Contrarian Investing: A Closer Look

Contrarian investors go against the grain and seek to identify opportunities that typical investors fail to see. Here we explore the philosophy behind contrarian investing and examine some contrarian bets that have paid off big time.

Published on 5 January 2018

Successful investing is very often a matter of timing. Buy when market sentiment is low and you have won half the battle – that’s exactly what contrarian investors do. The art of contrarian investing actually is very simple: purchase securities or other assets when most people predict that prices will continue to remain at low levels. If the market rises, they sell and make a profit.

But if the popular opinion remains pessimistic or if the market doesn’t change direction, a contrarian investor could be in for a long wait.

Consider Japan’s stock market. The Nikkei 225 peaked at a level of 38,916 on 29 December 1989, and subsequently crashed. A contrarian investor could have thought that buying when the index was, say, at 30,000, was a bargain. After all, that’s a discount of almost 25% off the peak. But anyone who had bought at that level would still be waiting for the market to recover. Even after 28 years, the Nikkei is still short of 23,000.

However, if your contrarian bet does pay off, you can make tremendous gains.

The man who broke the Bank of England

Contrarian Investing, Warren Buffett, George Soros, Howard Marks

George Soros is arguably the most successful contrarian investor. A Hungarian by birth and a graduate of the London School of Economics, Soros began life as a railway porter and a waiter.

Soros made his billions in the foreign exchange market. Back in 1992, Britain’s economy was floundering and the unemployment rate was at 12.7%. At that time, the value of the British pound didn’t float freely, but was determined by the European Exchange Rate Mechanism (ERM).

Sure that the pound was going to crash, Soros’ Quantum Fund took a US$10 billion short position against the British currency. On 17 September 1992, the British government decided to float its currency. Shortly after that, the pound fell by 15% versus the Deutschmark and 25% versus the US dollar.

The Quantum Fund gained US$7 billion from this fall and Soros personally pocketed in excess of US$1 billion.

Contrarian investing explained

Contrarian Investing, Warren Buffett, George Soros, Howard Marks

Howard Marks, the co-founder and co-chairman of Oaktree Capital – an investment management firm with assets under management of US$101 billion – warns against following the herd mentality when making investment decisions.

According to Marks, most investors blindly follow what others are doing. The cycle works like this:

  1. Economic conditions follow a cyclical pattern. Businesses prosper for a certain period of time and then the environment changes and the economy slows down or even contracts. Subsequently, this sequence of events repeats itself.
  2. Investors are strongly influenced by these ups and downs.
  3. In good times, investors are excessively euphoric. They think that company profits and share prices will go on rising endlessly. Asset values are pushed up to levels that defy logic.
  4. Conversely, when markets crash, most investors become overly pessimistic. In this situation, stock values are hammered to unrealistically low levels.

In both good times and bad, the contrarian investor sees opportunities to profit. But taking a position based on the opportunities that you identify can be difficult. According to Marks, “Most people are driven by greed, fear, envy, and other emotions that render objectivity impossible….”

Currently, he’s cautioning investors about the euphoria about FANG stocks. Marks says that the willingness to buy shares in Facebook, Amazon, Netflix, and Google-parent Alphabet at any price is “worrisome”. His warning seems to make sense considering that Amazon is trading at a price-earnings ratio of around 293 and Netflix at 191.

Is the S&P 500 going to crash?

Contrarian Investing, Warren Buffett, George Soros, Howard Marks

The current bull run of the S&P 500 started at the beginning of March 2009 soon after the global financial crisis. At that time, the S&P 500 index was at a level of 680. Since then, it has risen steadily to its current level of about 2,650. The index has exhibited an increasing trend for the last 105 months.

In the last 12 months, the S&P 500 has increased by 18%. Contrarian investors may think that after increasing so rapidly over the last year, the index may now be set for a fall. A decrease in share prices could be imminent, especially as the index has been climbing for over eight years.

However, it’s not as simple as that. Just because the bull market lasted for so long, it doesn’t mean that it is going to end anytime soon. The rally that began in December 1987 and ended with the dotcom crash in 2000 lasted much longer. That 13-year run saw the S&P 500 grow seven-fold from a level of a little over 224 at the end of 1987 to over 1,500 in March 2000.

Two investors who got it right in 2008

Contrarian Investing, Warren Buffett, George Soros, Howard Marks

The global financial crisis was precipitated by the crash in US property prices. In 2008, the world’s financial system was in danger of collapsing and the American government had to step in with a US$700 billion fund to purchase distressed assets, especially mortgage-backed securities, and stabilise the markets.

In 2008, the S&P 500 lost 38.5% of its value. But there were several investors who took a contrarian approach and made money out of the crash.

In October 2008, Warren Buffett announced that he had begun acquiring American stocks to take advantage of the low prices. He also purchased US$5 billion in perpetual preferred shares in Goldman Sachs. These paid him an interest rate of 10% per year and could be repurchased by Goldman at a premium of 10%. The investment bank desperately needed cash to tide over the crisis and was willing to pay practically any price to access funds.

Buffett entered into a similar transaction with General Electric, buying US$3 billion in perpetual preferred stock that carried a 10% interest rate and a 10% redemption premium.

Another investor who got his timing right was John Paulson, founder of Paulson & Co, a hedge fund. He reportedly made US$15 billion for the funds that he managed by shorting the US housing bubble.

The bottom line

So, how easy is it to go against the grain and make contrarian investments? If your trade is made on the basis of news that you have seen on television or read in the newspaper, you’re probably too late. The share price would already have factored in any major development within seconds.

The best advice for contrarian investors comes from Warren Buffett, who says, “… be fearful when others are greedy and greedy only when others are fearful.”