On Contrarian Stock Picking

To be a successful investor requires us to take a contrarian position. We are able to fool ourselves into thinking we are contrarian investors when in fact we are just following the herd. These are my notes from an essay by Matthew M Stichnoth “The Psychology of Picking Stocks” from The Psychology of Investing.

The essay begins with the old joke of the drunk searching for his car keys under a street lamp. A policeman joins the search and after a while asks the drunk “where did you actually lose your keys?”

The drunk replies “around the next corner at the end of the street.”

“Why are you looking for them here instead of where you lost them?”

“I’d never find them there, there’s not enough light.”

This is how most investors pick stocks, they only look at the ones in the media now, they don’t hunt for them in the dark corners where the true bargains are.

This is a very old concept, based on the fact that the markets go to extremes and must self correct over time.

  • First, a small group of investors come up with a conclusion (cabbage patch dolls will sell well this Xmas) and they invest in relevant stocks which stand to benefit.
  • Then as their conclusion shows early signs of being correct (shops sell lots of dolls), the stocks begin to rise and more investors show interest.
  • But the second wave of investors will need their stock to go higher than the first group’s in order to justify their profit expectations.
  • Next, these new, higher expectations are met.
  • Then more people become investors based on even higher expectations.
  • In the end, there is a horde of investors with wildly hopeful expectations, while the pool of new buyers dwindles.
  • Finally, the sky high consensus is shown to be too much and the market crashes.

An investor who can stand back while expectations are peaking, and who can buy when consensus is at its lowest point, can make a fortune.

Contrarianism is the basis for all investing. The momentum trader is betting that the consensus view isn’t bullish enough. Value buyers are implicitly saying the market has mispriced his company. Even the buy and hold investor believes that nothing terminal will happen to his stock, regardless of what the consensus thinks.

Avoiding contrarianism
It is against human nature to act in a contrarian way, even though we know that we must do so in order to be successful traders. So we justify our conformist choices by deluding ourselves into feeling as if we are contrarians by using stock picking methods such as astrology, ‘socially responsible’ investing and technical analysis. None of these are particlularly harmful investment methods, but none of them are particularly successful, either.

The worst avoidance device is to use the computer to screen for ‘cheap’ stocks. The problem is that everybody else is already doing this and they are doing it in the same way, using the same screening parameters (multiple of book value, % revenue growth, % debt etc). And they are using the same data, which is disclosed to everyone at exactly the same time.

Using screening methods, everyone comes up with the same investment decisions. That is not conrtraian investment.

Painless contrarianism
Stichnoth gives three tips for stock picking which do not rely on screening but which give you a chance to find stocks with good potential.

Insider buying
Heavy buying by company insiders (especially by a CEO) are a good indication the market has overdone its pessimism. But you should watch out for companies that make stock-purchase loans to their executives, or ones that require their executives to own shares.

These are unloved by their very nature. They are spun off from their parent company only because no buyer could be found. So the stock is distributed to the owner’s shareholders. Many of the shareholders don’t want the stock they’ve been issued and they sell it as soon as possible. As they all exit the stock at the same time, the price is depressed regardless of its value.

Busted IPOs
Some stocks sink soon after floating. This is sometimes because of a single bad quarterly report or management may be struggling to adjust to operating as a public company. These stocks can stay low for ages. Once these (often simple) problems are fixed, the company may be re-rated.

I would only add that you should be careful with that last tip. Often an IPO sinks for very good reasons and never recovers its original price.

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