Value Investing and Contrarian Thinking

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. 

Where may value exist?

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. 

Contrarians are almost always initially wrong

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. 

When contrary opinion can be put to use.

Holding a contrary opinion is not always useful to investors, however. 

1.  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. 

2.  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. 

Value Investing and Contrarian Thinking

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.  

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 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.

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.

Ref:  Margin of Safety by Seth Klarman

****3 Steps To Profitable Stock Picking

3 Steps To Profitable Stock Picking

Stock picking is a very complicated process and investors have different approaches. However, it is wise to follow general steps to minimize the risk of the investments. This article will outline these basic steps for picking high performance stocks.

Step 1. Decide on the time frame and the general strategy of the investment. This step is very important because it will dictate the type of stocks you buy.

Suppose you decide to be a long term investor, you would want to find stocks that have sustainable competitive advantages along with stable growth. The key for finding these stocks is by looking at the historical performance of each stock over the past decades and do a simple business S.W.O.T. (Strength-weakness-opportunity-threat) analysis on the company.

If you decide to be a short term investor, you would like to adhere to one of the following strategies:

a. Momentum Trading. This strategy is to look for stocks that increase in both price and volume over the recent past. Most technical analyses support this trading strategy. My advice on this strategy is to look for stocks that have demonstrated stable and smooth rises in their prices. The idea is that when the stocks are not volatile, you can simply ride the up-trend until the trend breaks.

b. Contrarian Strategy. This strategy is to look for over-reactions in the stock market. Researches show that stock market is not always efficient, which means prices do not always accurately represent the values of the stocks. When a company announces a bad news, people panic and price often drops below the stock's fair value. To decide whether a stock over-reacted to a news, you should look at the possibility of recovery from the impact of the bad news. For example, if the stock drops 20% after the company loses a legal case that has no permanent damage to the business's brand and product, you can be confident that the market over-reacted. My advice on this strategy is to find a list of stocks that have recent drops in prices, analyze the potential for a reversal (through candlestick analysis). If the stocks demonstrate candlestick reversal patterns, I will go through the recent news to analyze the causes of the recent price drops to determine the existence of over-sold opportunities.

Step 2. Conduct researches that give you a selection of stocks that is consistent to your investment time frame and strategy. There are numerous stock screeners on the web that can help you find stocks according to your needs.

Step 3. Once you have a list of stocks to buy, you would need to diversify them in a way that gives the greatest reward/risk ratio. One way to do this is conduct a Markowitz analysis for your portfolio. The analysis will give you the proportions of money you should allocate to each stock. This step is crucial because diversification is one of the free-lunches in the investment world.

These three steps should get you started in your quest to consistently make money in the stock market. They will deepen your knowledge about the financial markets, and would provide a of confidence that helps you to make better trading decisions.

http://tradingindicator.blogspot.com/2010/01/3-steps-to-profitable-stock-picking.html

Comment:  There are many ways to make money.  Investing for the long term is profitable for many investors.  Some of those who employ other strategies can also be profitable too.

Leaning against that powerful tide

The crowd can be correct during much of a long trend, but always overstays and proves itself wrong at turning points.  When the feeling of bullish rightness becomes universal and powerful, a top is immediately at hand. 

Being successful in investing or trading means leaning against that powerful tide, which then creates psychological, financial and social stresses and strains not everyone can handle. 

If by nature an investor is passive, a follower, he may lack sufficient courage to do what is required for investing or trading success.  But if one can stick to contrarian principles despite probable early suboptimization of profits, he acquires a bucketful of cash near the top (plus some interest) for use later when the panic phase arrives. 

Why the Efficient Market Theory is Both Right and Wrong

Why the Efficient Market Theory is Both Right and Wrong

Once upon a time a couple of enterprising university professors got together and proclaimed that the stock market was efficient, meaning that on any given day a stock was accurately priced given the information available to the public. They also concluded that because of this efficiency, it would be impossible to develop an investment strategy that could do better than the market did as a whole. Because of the market's efficiency, they concluded, the most profitable approach to investing would be through index funds that go up and down with the rest of the market. (This type of fund buys a basket of stocks, without regard to price, representing the stock market as a whole.)

Warren Buffett recognizes that because 95% of all investors are hell-bent on trying to beat each other out of the quick buck, the stock market is very efficient. He sees that it is impossible to beat these people at their short-term game. He also realizes that the shortsighted investment mind-set that dominates the stock market is completely devoid of any true long-term investment strategy. You only have to look to the options market to see hard evidence of this.

• Short-term options trading, up to 6 months out, is a fully developed market with multiple exchanges, writing tens of thousands of option contracts, on hundreds of different companies, each and every day the stock market is open.
• The so-called long-term options market, up to 2 years out, is tiny and deals in fewer than fifty stocks. From Warren's investment perspective, 2 years out is still short-term.
• No exchange has an active options market writing contracts 5 to 10 years out. It simply doesn't exist.

Warren's great discovery is that, from a short-term perspective, the stock market is very efficient, but from a long-term perspective, it is grossly inefficient. He had only to develop an investment strategy to exploit the shortsighted market's inefficient long-term pricing mistakes. To this end, he developed selective contrarian investing.