- Below, I will clear up an all too common misconception perceived by market participants.
- Some traders and investors alike believe that value investing and contrarianism are perfectly aligned or very similar, which is simply not the case.
- High-safety equity investments crucially require valuation, where contrarian thinking is situational and certainly not essential.
I have heard time and time again from a variety of people who involve themselves in capital markets that value investing and contrarianism are practically the same thing. The thesis behind this is that value investments only rear themselves when a stock is heavily oversold, hated, or the opportunity can be obviously recognized. Similarly, contrarianism is going against the common market belief (or trend) of a given company/stock. In other words, if a stock has plummeted (i.e. 25, 40, or even 60%), some people would say that value investors (aka contrarians) would definitely consider looking at a company, or just buy the stock because it looks fundamentally sound and appears oversold. Just take a look at the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) during the financial crisis lows! Value investment, check, and contrarian, check. Below, I will explain how this thought process or general assessment is entirely inaccurate.
As defined by Investopedia: "An investment style that goes against prevailing market trends by buying assets that are performing poorly and then selling when they perform well."
This is correct, but not fully inclusive. On the other side, they may also consider shorting businesses trading at high premiums (not necessarily elevated stock prices), or betting against a company that has an unsustainable business model. Contrarians can be sub-categorized into technical, news-driven, fundamental, sentiment, etc. In fact, there are a handful of contrarians that don't even bother with valuation at all.
A current example is Whole Foods Market (NASDAQ:WFM). This is one of the worst-performing S&P 500 stocks YTD, and needless to say, it's not just Wall Street that has been eyeing it, but retail investors as well. I have had about 10 people ask me if they think Whole Foods is a good choice in the last few months. The reason they like it is because it has fallen so much and view it as an opportunity. This is by definition the mindset of a contrarian, however, it doesn't necessarily impose the consideration of valuation. In fact, Whole Foods could very well be overpriced, despite the fact that it has fallen 40% of its highs. These people could have been asking if WFM was a good pick at $50, $45, $40 (or maybe the possible future price of $30). Furthermore, contrarianism (although helpful in some scenarios) can more often than not lead to detrimental outcomes. This is an all-too-common situation, where people attempt to catch falling knives or possible stock bottoms. A company I recently wrote about was Millennial Media (NYSE:MM), which is undoubtedly a great contrarian play, but a value play? Probably not, at least in my opinion.
Anyone who has heard about Buffett, Graham, or any bottom-up investor knows that their methodology closely follows valuation. The simplest and most direct method is discounting cash flows of a business; the problem is actually figuring out what these cash flows will be in the future. Otherwise, there are a variety of evaluations that investors, bankers, and so forth conduct to value firms, commonly done through modeling.
An easy example would be the following. Hypothetically, say Google (GOOG, GOOGL) was growing earnings at a consistent rate of 20% annualized. In a vacuum, the company would be worth purchasing at a share price <20% growth, say 19% or 18%. Not only do you have a net safety range, but also when the earnings are scaled out over the course of a couple decades, you will see outsized returns. Value investing isn't that easy, though, otherwise everyone in the world would be doing it. There are many quantitative and qualitative aspects of a business that investors need to consider and include the factorization of potential risks going forward. Here's an interesting fact: apparently only 20%-25% of all mutual funds actually outperform the market, and they are considered to be the professionals!
In any event, the key point is that the value investment process does not necessarily have to be contrarian. In fact, there are many value prospects that trade near multi-year highs or appear to be relatively overbought at times. An easy example would be Wells Fargo (NYSE:WFC); if you take a glance at the stock chart, you will see that the company traded no higher than $33 pps for about 10 years up until 2013 (excluding 2006 and 2007). So why would someone purchase the company above that price in 2013?
It may sound obvious in hindsight, but idea is that WFC was not contrarian in the slightest, yet presented an outstanding value play, earning 50+% in the last 18 months, outperforming the S&P by more than 10% (not to mention, this was a mega-cap).
Sidenote: The earnings growth example on Google mentioned above is obviously only one of many ways investors can value businesses.
While contrarians and value investors may be similar in some aspects, they are far from the same type of market players. In general, value investors will more often than not outperform contrarians on an absolute basis (and speculators as well, excluding anomalies like George Soros). Although I will say that speculation and contrarianism alike has helped many people through history protect investors/traders from major losses and/or produced outsized returns. In my opinion, if a person is adept at valuation, macro-economics, statistics, technical analysis, gauging sentiment, and so forth, that only helps the stars align in making critical decisions going forward. Clearly, there are many ways to make money in the market. The goal is not to over complicate investing, but to understand why markets move the way they do and leverage that information for a profit.