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Contrarian Investing

Profit from Bad News

Contrarian Investing - Profit from Bad News; picture of investor carrying a large money bag from a pretend city drawn on a blue background board

Speculation fuels the stock market which drives stock prices higher. The momentum created continues to drive prices higher as more and more speculators buy the stock. These speculators build up their open profits as the stock price continues to climb.

Then some event occurs which shakes the confidence of these speculators and they sell their stock. This increases the supply of stock for sale which in turn drives down the stock price. The trend has now changed direction and heads downwards.

It's this short-term view that drives stock prices down with speculators buying on good news and selling on bad news, regardless of the company's long-term prospects.

This is the classic herd mentality that is driven by the financial media which fuels the short-term price swings but has nothing to do with the long-term business prospects of the company.

The Contrarian Investor

The Contrarian investor invests in what other investors find unattractive. These are stocks that have recently performed poorly and have fallen out of favor with investors. This ensures that the stock price is relatively low. But a low stock price is not in itself reason enough to invest in a company.

The company also needs to be financially secure over the long-term as well as have some form of competitive advantage which will help ensure the company's long-term survival. Companies with businesses dealing with consumer products and/or services that have a semi monopoly with their brand names tend to have an advantage.

These companies have products or services that people need and will continue to buy into the future irrespective of what the stock price does in the future. It's this future demand for the company's products or services that help drive future profits and therefore its future stock price.

Contrarian Investing - Profit from Bad News; picture of newspapers on a computer screen and on a table screen and also on a phone screen

The Stock Price

Stock prices are quite sensitive to news events. A good earnings report can see the stock price move up. A bad earnings report can see the stock price move down. Investors don't care if all indications are that the earnings will improve over the next year or two. Investors are only concerned about what is happening now.

Investors typically have a short-term view. If news about a stock looks good now then they will buy the stock, but over the next weeks or months these investors will sell if the news then looks bad. This is irrespective of the company's future business prospects.

This is one reason why mutual funds have high turnover rates. They buy and sell based on news events in an attempt to outperform other mutual funds on order to earn the Top Fund of the Year title. This buying and selling - while increasing market liquidity - also increases market volatility. At first this may seem like a bad thing, but it can lead to a buying opportunity for the contrarian investor.

The bad news phenomenon happens virtually every day to one stock or another. Simply read any of the internet market reports or watch the business report on television and you'll see that after any negative news on a company is announced, the price of its stock drops. If the news is really bad and the news is realized when the stock market is closed, the stock price typically gaps down significantly when the market opens in the morning.

The irony is that most investors buy the stock with the view to being stock investors over the long haul but their short-term actions lead them to speculation. Now there is nothing wrong with speculation - it's just that most investors insist that they are investors while their actions dictate that they are speculators!

Mr. Market

The famous investor Benjamin Graham had a novel view on the action of stock prices - which he referred to as Mr. Market.

On some days Mr. Market was wildly enthusiastic about the immediate future of a stock and would ask for a high selling price. On doom-and-gloom days, when he was overly pessimistic about the immediate future of the stock, he quoted you a low selling price.

If the Contrarian investor thinks that the long-term prospects for the business are good and would like to buy some stock, then when should they take Mr. Market up on his offer? Should it be when he is wildly enthusiastic and quoting a high price? Or should it be when Mr. Market feels pessimistic and quotes a low price? Obviously when the low price is quoted!

Contrarian investors are only interested in the price that Mr. Market is quoting, they are not interested in Mr. Market's thoughts on what the company's business is worth.

A lot of investors are under the belief that Mr. Market accurately prices the stock and this is what the stock is worth. In other words, the stock price at any given point in time is the stock's valuation at the point in time. Now this works for private businesses and would be true for public companies except for one very important difference.

The only people who buy private businesses are people looking to buy a business, whereas with public companies it's mostly speculative buyers who have absolutely no interest in the companies business and their only concern is that the stock price continues higher. If the stock price falls - they sell.

To sum up - the difference is public companies are bought by people who have no interest in the companies business; whereas private businesses are bought by people who want to run a business.

Now since public companies are bought by people who have no interest in the business then how can the markets stock price reflect what the business is worth!

Keep in mind that the stock price is the price per share - there are only ever a fraction of the company's shares sold at any one time - its not the entire company sold in one go like it is with a private business.

Buying in Bear Markets

There are certain repetitive types of market, industry, and business conditions that produce the best pricing for stocks.

The simplest event for investors to spot is a Bear Market which essentially affects the entire stock market. While Bear markets are relatively rare they do regularly appear over the decades.

Graph 1. below shows how bear markets follow bull markets which in turn leads to the next bull market and the cycle repeats over again.

Graph 1. Stock Market Cycles

Profit from Bad News Graph 1. Stock Market Cycles showing bull and bear market phases

Most investors absolutely hate Bear markets due to the fact that their portfolio value drops, but Bear markets are a natural part of the stock Market cycle.

In contrast to most investors, Contrarian investors love Bear markets - firstly they acknowledge that Bear markets occur from time to time so it's no surprise when the next one comes along, and secondly they know that they can buy great stocks with strong businesses at ridiculously low prices during a Bear market, and thirdly they know that Bear markets are short lived and stock prices quickly recover when the next bull market gets going.

So when it's all over the Contrarian investor ends up with a stack of great stocks bought at bargain basement prices.

Other Buying Opportunities

While bear markets are great for buying fantastic stocks at ridiculously low prices, there are some other events that occur which can cause a stock's price to fall so that Contrarian investors can pick up a bargain. These include industry recessions, individual calamities, changes in corporate structure, and war.

INDUSTRY RECESSIONS: An entire industry suffers a financial setback. This usually affects all companies operating in that industry. Companies that only conduct business in that industry are really hit hard with massive falls in profits. Companies that also operate in other unrelated industries are less affected. The effect is only minimal if the company only derives a small portion of its earnings from the affected industry. Usually the financially strong companies survive the industry recession while the financially struggling companies are at risk of bankruptcy.

INDIVIDUAL CALAMITY: Sometimes management of brilliant companies do stupid things. This is a part of corporate life. A company with a competitive advantage will likely find its profits affected when management does something stupid, but if profits have plunged (thus providing a potential buying opportunity) then they are more likely to recover quickly. A company that has the financial power of a competitive advantage behind it has the strength to survive almost any calamity.

STRUCTURAL CHANGES: These can produce special charges against earnings that have a negative impact on stock price. Mergers, restructuring, and reorganizing costs can have a negative impact on net earnings. These are short-lived and can provide the Contrarian investor with a buying opportunity.

WAR: The threat of war can send stock prices downward regardless of the time of year. This will affect most of the market with the only possible exception being companies that provide military equipment. The uncertainty and great potential for disaster will affect most stocks. The sell-off is motivated by outright fear, which results in investors selling stocks. Sooner or later the conflict is over and the low prices lead to buying opportunities.

Don't Play the Market

Contrarian Investing - Do not Play the Market; picture of playing cards depicting a gambling poker game for taking a risk

Playing the stock market is a term used to describe the action of taking a punt on a stock or stocks. This is similarly to playing poker or taking a punt at the horse races and it's considered gambling.

The world's richest investor Warren Buffett doesn't play the stock market; rather he selectively picks stocks with the fundamentals his looking for and buys when the stock price is attractive. He then usually holds his stocks for a long time

Warren Buffett does not believe in playing the stock market like most investors do who frequently follow the current investment trends. He also doesn't use chart stocks.

Most investors look for stocks where the stock price is raising fast, and find stocks unappealing if the stock price falling.

Throughout Warren Buffett's investing life he has avoided every investment theme to sweep the financial world. He avoided the Internet revolution and the technology boom of the 1990 including the dotcom bubble.

Warren Buffett made his fortune by investing in companies rather than speculating in the stock market. But there is more to investing than merely buying stocks and holding them over the long-term.

Most investors and financial institutions (like mutual funds) play the stock market in search of quick profits. They are looking for the fast buck, the easy dollar. When things look bad and stock prices fall, they quickly become pessimistic and sell. Warren is the ultimate exploiter of this pessimism and selectively buys if the company meets his criteria and the stock price is right.

What sets Warren Buffett apart from the rest of the investing community is that he looks to buy his selected stocks at cheaper prices. In other words he looks to buy what others are selling.

This approach to investing can best be described as Opposing or Contra investing. The term Contrarian Investing is an appropriate term to use.

Contrarian Investing - Do not Play the Market; picture of calculator on top of a pile of money with writing saying money in large blue letters as a sign

The Contrarian Investor

Some investors might immediately think that Contrarian Investing means buying any stock that is cheap. There are two issues here - the first is Any and second is Cheap.

First let's deal with Any. While stock prices for a particular company may have fallen to cheap levels this does not automatically mean that the stock is worth buying. The company may be unattractive fundamentally with little future prospects - there is no point in buying tomorrows bankruptcy.

Secondly let's look at Cheap. This raises a whole new issue and that is what do we mean by cheap. How do we know when the stock price is cheap? Just because the stock price has fallen does not necessarily mean it is cheap - the stock may simply not be as expensive as it was but it may well still be expensive.

As one might think, the master Contrarian Investor Warren Buffett has these two issues worked out to a tee.

The first issue whether to even consider the stock, Warren Buffett looks at not only the company's financials but also considers the company's business operating environment. He likes companies that deal with consumer products and/or services and also have a competitive edge giving them a monopoly effect. These are companies that will likely still be around in the future even if they are suffering in the current operating climate.

The second issue dealing with stock price, Warren Buffett actually does not care if the stock price is cheap, what he looks at is the potential future stock price appreciation over the next decade. In other words, he calculates the future stock price and then decides the percentage return he is after and this allows him to calculate the maximum stock price he is wiling to pay.

If the stock meets all of the above fundamental criteria and the stock price is below his predetermined limit then he accumulates stock in that company.

Driving Down Stock Prices

Momentum investing is a popular style of investing which involves buying stocks in uptrends. The tactic works well while the stock price maintains its upward momentum. But when the market turns down or some negative issue arises with the company, the stock price can fall quickly as speculators sell. The stock price continues to fall as investors abandon the stock where their selling continues to drive prices down.

It's this short-term view that drives stock pries down with investors buying on good news and selling on bad news, regardless of the company's long-term prospects.

This is the classic herd mentality that is driven by the financial media which fuels the short-term price swings but has nothing to do with the long-term business prospects of the company.

The good news that gets investors to buy can be anything from a headline announcing a prospective buyout or a quarterly increase in earnings or simply a stock with a rising price that is featured in the press.

The bad news that gets these investors to sell their stock can be anything from an industry recession to missing a quarterly earnings projection or simply a stock with a falling price that is featured in the press. The long-term business prospects of the company are often totally ignored.

Short-term speculation can overvalue a stock quite easily and quickly. This leaves the stock price venerable to a decline when there is anything that might threaten the continuation of the price advance. This gives the Contrarian Investor an opportunity to buy while the stock is out of favor.

The Best Companies to Invest in

Contrarian Investing - The Best Companies to Invest in; picture of a business man carrying a brief case walking away from the city on a highway road

There are many differing investing views on what sort of companies make a great investment. Indeed there are many different investing views on how long a stock should be held.

For the purpose of this article we will look at what characteristics make a great company for a contrarian investor. As for the time-frame we will assume a buy and hold - this way we can concentrate on the company's merits rather than concerning ourselves with the future stock price movement.

The Selective Contrarian Investor

The traditional contrarian investment philosophy is to buy stocks that are out of favor when the stock price is considered cheap enough. The problem with this simple approach is that it does not look at the long-term future prospects of the company's business.

The approach taken with this article is to selectively pick companies which have the financial capacity together with a competitive edge that will allow them to survive and prosper beyond the negative news that drove down its stock price.

Therefore this is not the traditional contrarian investor approach of bottom picking stocks.

By selectively picking the cream of the crop over time the stock price will more likely fully recover and continue upwards.

In order to find these stocks, their businesses are separated into two categories. This is essentially the same approach used by Warren Buffett.

Price Competitive Business: These sell commodity type products or services. A price competitive business manufactures or sells a product or service that many other businesses sell and competes for customers solely on the basis of price.

Durable Competitive Business: A company with a durable competitive business typically sells a brand-name product or service that holds a privileged position which allows it to set its price for its product or service. These businesses face little or no competition which creates a monopoly effect. It's the durable competitive businesses that have not only the greatest potential to recover from a setback but also have the greatest potential for long-term profit growth well into the future.

How Companies Make Money?

Having a basic understanding of how companies make money helps investors to locate the better stocks to buy.

Let's assume a hypothetical company makes cookies which it sells for $3 a packet. We'll assume these cookies cost $2 a packet to make. The difference between the selling price and the cost to make them is the company's profit margin. In this case the profit margin is ($3-$2=$1).

The higher the profit margin is then the more profit the company will make for each packet of cookies sold.

For every $1 million profit made per year this company will have to sell one million packets of cookies per year.

Now if this company wants to increase its profitability, one of two things must happen: either the profit margins must increase or the number of cookies sold per year must increase (this is referred to as inventory turnover).

If the company makes super delicious cookies then the company might be able to increase its sale price to say $4 per packet and perhaps sell them in a niche market. If the sale price can increase then profit margin goes up. If the company can maintain the same revenue level (inventory turnover) then the annual profit increases. However, if the turnover falls then the annual profit might actually decrease.

Turnover Effect on Increased Sale Price

Existing Sale Price = $3 and selling One million packets = $3 million revenue

Less costs of $2 per packet leaves $1 million profit

1. If turnover remains the same:

New Sale Price = $4 still selling One million packets = $4 million revenue

Less costs of $2 per packet leaves $2 million profit

2. But if turnover halves:

New Sale Price = $4 but selling 1/2 million packets = $2 million revenue

Less costs of $2 per packet leaves $1 million profit

As we can see from the above simple example, a company increasing its sale price does not necessarily mean that its profits will increase - it all depends on how its inventory turnover is affected, which can easily decline if not enough consumers are prepared to pay the new higher price. If turnover declines enough the company's profits will actually decline even though they are selling for a higher price. In the above example profits will drop if the inventory turnover drops below 1/2 million packets.

Companies with brand loyalty are more likely able to increase their prices. These companies have a monopoly like effect.

A company trying to increase their sale price (which increases the profit margin) is one way to increase profits. The other way is to increase inventory turnover.

Let's again look at out cookies company example. With its new super delicious cookies the company might be able to increase the quantity sold and thereby increasing its profits with the existing sale price (Hence the profit margin per packet is the same).

Increasing Turnover with the Same Sale Price

Existing Sale Price = $3 and selling One million packets = $3 million revenue

Less costs of $2 per packet leaves $1 million profit

1. If turnover increases 50%:

Same Sale Price = $3 but selling 1.5 million packets = $4.5 million revenue

Less costs of $2 per packet leaves $1.5 million profit

2. If turnover doubles:

Same Sale Price = $3 but selling 2 million packets = $6 million revenue

Less costs of $2 per packet leaves $2 million profit

As we can see from our cookie company example, if inventory turnover increases 50% then the profits increased by 50% for the same sale price. With a doubling in inventory turnover, the profits also doubled - thus there is a direct linear relationship between inventory turnover and profits. By whatever percentage the inventory turnover increases the profits increases by the same percentage.

Companies often face competition which makes it difficult to increase prices, so the alternative way to increase profits is to increase turnover.

If the company lowers its prices to attract more customers, then their competitors will probably do the same thing - which only leads to lower profit margins.

Companies with a competitive advantage are better placed and more likely able to increase turnover without needing to lower prices thus preserving their profit margins

Companies that operate with low profit margins and also low inventory turnover will find it extremely difficult to increase their profits. Conversely companies that operate with high profit margins or high inventory turnover will find it much easier to increase their profits.

The best companies operate with both high profit margins and inventory turnover. These companies find it the easiest to increase their profits. These companies typically have a competitive advantage and operate with a monopoly type effect.

What to Look For in a Company

The selective contrarian investment philosophy is to look for companies with a competitive advantage.

These companies are more typically found in the consumer based industries as brand loyalty leads to a monopoly type effect. The company will typically have sold the same product for many years. These companies save money on development costs and don't need to spend a lot of money on setting up new production lines.

Another characteristic of companies with a monopoly type effect is that they tend to have fairly consistent profit increases per year. This is in contrast to a lot of companies which have widely swinging profits over the years - big profit one year followed by a huge loss the next year followed by a breakeven profit and so it goes on.

Companies with a competitive advantage can sell a product or they can provide a service. These products or services can be aimed at the consumer or at businesses.

Companies with a Competitive Advantage

1. Companies with products aimed at the consumer

Ideally these products wear out fast or are used up quickly, and have brand-name appeal, and that merchants have to carry or use to stay in business. This includes anything from cookies to panty hose, from jewelry to furniture to carpet.

2. Companies in the Advertising industry

Pretty much all businesses that sell to consumers need to regularly advertise. Whether they sell a product (such as Coco Cola) or provide a service (American Express) they must advertise to keep their loyal consumers - otherwise a competitor will advertise and persuade their loyal customers.

3. Companies that provide repetitive services

These include insurance, tax preparers, cleaning services, security services, and pest control. These services are required and regularly used by both consumers and businesses.

The selective contrarian investment philosophy is to look for companies with a competitive advantage that are financially strong but are currently out of favor with the investing community. Such companies can be quite difficult to find but when the contrarian investor does find one (and sooner or later they do) they can make great long-term investments.

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