The Money Report: When to venture into the tricky world of contrarian investing

Money Report

When to venture inside the tricky, twisty world of contrarian investing

Steven WeberMost investment analysis involves some degree of fundamental research — the study of individual companies, sectors or markets and the economic forces that drive them higher or lower. Other strategies involve market timing — trying to discern where the markets are going and acting accordingly — or technical analysis, the process of studying price and volume changes in order to make near- and longer-term judgments on individual company stocks or the broader markets. You often hear investors say “Don’t follow the crowd,” but you’ll also hear them say “The trend is your friend.” We know there is safety (or at least comfort) in numbers. However, the discipline known as contrarian investing, which builds a sophisticated philosophy and strategy out of going against the grain, has considerable resonance for many investors.

Along with many other newly minted stockbrokers working at Rauscher Pierce Refsnes in the 1980s one of our major influences was David Dreman, former director of research for the firm and author of “The New Contrarian Investment Strategy.” Dreman engaged in extensive study of investor behavior, stock performance and the relative value of analysis and economic predictions. In an era of high-flyers, his innovative approach involved selecting stocks on the basis of low price/earnings ratios, or P/Es. These were relatively unpopular companies, those to which the markets gave little value to future earnings. When screened for size and financial stability, these out-of-favor companies as a group handily outperformed the higher P/E stocks of companies with greater support and expectations — and contrarian investing had a voice.

Classic “value investing,” an approach developed and refined by investment giant Benjamin Graham, involves buying stocks at less than fair value and holding them until they reach their fair, or intrinsic, value. This strategy has strong contrarian elements; typically, for a stock’s price to sink low enough to make Mr. Graham’s screen, the company must be out of favor, overlooked and pummeled by bad news.

Then there are the ‘Dogs of the Dow.” This contrarian strategy involves buying the 10 highest yielding stocks from among the 30 stocks that make up the Dow. Once each year, the 10 stock portfolio is rebalanced. Those stocks that are no longer on the list of “highest yielding” are sold and replaced with those that are.

Dow stocks, which are generally larger, more stable companies, are more inclined to protect their dividends than the average stock. So, these high-yielding stocks are usually there because they have become unpopular, and their prices have fallen while their dividend amounts have remained the same. There are other useful contrarian indicators that relate to the entire market. Volatility indexes such as the VIX measure changes in options prices and can indicate the level of bullishness or bearishness among options buyers and sellers. A high index reading indicates negative sentiment, while a low number indicates positive investor expectations. As you might have guessed, more often than not the negative sentiment of these investors proves, perversely, to be an indication of better things to come.

The AAII, or American Association of Individual Investors, has for many years published a survey of their members, which tend to be well-educated, affluent and self-directed. The bullish sentiment in this group slumped to a low of 12 percent in the fall of 1990, when the Dow was at 2,500, right before the beginning of the historic technology bull market. The survey’s most optimistic outlook for the future peaked in January 2000, at the height of the dot-com boom. The Dow was then at 11,300, and headed down.

Finally there are magazine covers, which have gained a reputation as contrarian indicators in their own right. Investors may recall the famous Business Week cover on Aug. 13, 1979, titled “The Death of Equities.” The Dow hit 875 that day; scarcely eight years later it had more than tripled. At the Bedminster Group offices we keep a framed New Yorker cover from Oct. 20, 2008; on it a black background highlights a red cloaked skeleton, a stock chart with bloody arrows plunging downward and a crowd of brokers below crying bloody tears. The Dow was at 9,265 that day, and would fall as low as 6,600 by March 2009. By then, more than 70% of all investors surveyed were extremely pessimistic about future stock returns. The stock market began to climb a wall of worry that month, and so far, hasn’t looked back.

Steven Weber, Registered investment advisor, and Gigi Harris, Dir., Client Communications, are members of the Bedminster Group, a feeonly advisor providing investment and financial counsel to clients in the Lowcountry since 1997.