Taking advantage of Irrational Behavior Strategy

This strategy is a variation of strategy #1. It looks at relative industry strength and investor sentiment.

Indicators

  • Down by 50% off 52 week low
  • Bottom of cycle
  • “Maximum market pessimism”
  • Low relative Price/Earning
  • Low relative Price/Sales
  • Low relative Price/Book
  • Low relative debt-to-equity
  • Interest coverage ratio
  • Cash flow

A Contrarian stock

 Down by 50% off 52 week high.

We talked earlier about how the media over focuses daily on individual companies and sectors. One thing that can be done is to listen to the popular press with an ear tuned for these extremes.

Phrases such as “disaster”, “doomed” and “dead” will be used to describe such a market.

Business Week once ran a cover declaring “Stocks are Dead”. Come on… As an Contrarian investor, the Media is simply not on your side of thinking. But this is used to the Contrarian advantage. The news media helps forge the mass opinion that contrarians try to go against. Remember we talked earlier about ‘Experts’. Experts are a real contributor of mass opinion. So once again Expert confidence in their opinions is seen. When there is a consensus – it represents an extreme in opinion.

Lets be honest, the Media by its very nature must sell papers, magazines and its television programming to a competitive viewing audience. It must make interesting content where no content exists to sell their medium. Their ultimate goals is to sell Advertisements first and provide content second.

It still seems irrational to believe that everyone can be wrong about something? Think about this.

People feel comfortable when they are with the crowd. As a society, we are told to conform. This makes people very susceptible to what is called Group Think. Group Think occurs when everyone within a group thinks the same way. Society actually encourages group think in encouraging team structure where people work together on a common vision. Within a team, when a member provides an opinion that is not consistent with the rest of the group, that member is either ignored or overruled by the majority. There is no encouragement or positive reinforcement to go against ‘group think’ because it is viewed by other teams members as ‘uncooperative’ and ‘out of touch’. So we are all naturally conditioned to think in away which seeks society approval.

So as a Contrarian, you are going to have to recondition yourself to trust your own ability to perceive, interpret and evaluate the environment around you independent of your peers, society and the crowd. This is not easy to do. It is a trade off – you will receive comfort and encouragement if you go with the crowd, or you will receive solidarity if you think independently. These are some of the reasons why people go with the crowd and why the crowd is most often wrong.

Investing in stocks is a strange transaction. It is the only product in which the more expensive the product gets, the more customers that want to buy them. That doesn’t happen normally for buying a Television, a car or a house. Usually people shop for bargains and want to pay the lowest price possible for a good.

In the market, people are doing the exact opposite of what they should be doing. When a stock rises, investors believe that a stock will continue to rise, in a gold rush mentality. Most investors become interested and start buying. Investors are attracted to action, by the potential for profit. People have a way of projecting into the future a straight line based on the past. Unfortunately, this rarely continues. When stocks begin to drop, most investors are not afraid because of the previous reinforcement of gains. This path results in a buy high, sell low result. Not too smart.

Capitalizing on such “extreme” opinion is the core of contrarian investing. Consensus building and extreme opinion created the tech bubble. JDSU is a clear example of optimism and extreme opinion. A clear example of buying high and selling low for many investors.

The following contrarian strategy uses a set of criteria that help remove the subjectivity of what is ‘out of favour’. These indicators help form a proxy for investor sentiment.

Strategy:

The price of a company’s stock in an auction-style market such as the NYSE or the TSE can reach dramatic heights of volatility over the course of a year. The value of that same company rarely fluctuates with the same ferocity. The 52-week highs and lows are a good place to start when studying a stock. If a large number of companies in the same industry are near their 52-week lows, there’s a good chance that the industry is out of favour. The key is to distinguish between the companies that are out of favour with justification, and those that are out of favour without rational justification. To determine whether a company is down by 50% off its 52 week high, simply check to see if the current price of the company is less than half of its 52W High. If it is, you may be on to something.

 Bottom of cycle.

One of the most difficult aspects of timing your purchase is determining when an industry is at the bottom of its cycle. An industry is usually at or close to the bottom of the cycle when there appears to be maximum market pessimism. Warren Buffett once said that “optimism is the enemy of the rational buyer.”

 “Maximum market pessimism”

While there is no true objective measure for determining maximum market pessimism, you can usually get a good feel for an out-of-favour sector merely by glancing at headlines in the financial section of your local newspaper. Dark or gloomy forecasts for an industry are usually good indicators that the bottom of the cycle is imminent.

The following indicators can be used as proxy for investor sentiment.

  •  Low relative Price/Earning
  • Low relative Price/Sales (Less than 1.0)
  • Low relative Price/Book (Less than 1.0)

 PAST EXAMPLES: TOBACCO

One dramatic Contrarian play was the Tobacco industry. It met the our three Step-1 indicator. We analyzed two companies that are leaders in this sector: Phillip Morris (M) and RJR Reynolds (RJR)

Down by 50% off 52 week high

Both Phillip Morris and RJR met this criteria. For example, in prior years Phillip Morris averaged around $40 (peaking close to $60). At $19, it met our “Down by 50″ rule. We bought!

Bottom of Cycle

While Tobacco will always have a steady market (nicotine is addictive and most people are weak), the industry was under appreciated during the recent irrational technology boom (see Irrational Exuberance). The market ignored high dividend yields, steady revenues, profitability and cash flow. Instead it chased “Castles in the Sky” like eToys (with a market cap greater than Toys R Us) or Pets.com. Not too smart!

Maximum Market Pessimism

During the time, the great masses thought the courts would destroy big tobacco with frivilous lawsuits. Obviously this did not happen. The market was to pessimistic.

The chart on the left illustrates the dramatic decline in the stock price of Phillip Morris. When we bought the stock at $19 it was well off of its 52 week high. We have since sold the stock at $50 for a whopping 163% return – in a one year period.Normally, we expect to hold on to a stock until the sector becomes “in-favor” again – which could take years. Thankfully, this play turned around in a year. We were very pleased with ourselves!

The chart on the left illustrate the decline and rise of the tobacco industry. At the same time it illustrates the irrational exurberance of the Nasdaq. A pure-play tobacco company like RJR would have had an even greater return than Phillip Morris.

CONTRARIAN INVESTING TAGS

  • Contrarian Strategy indicators or tips
  • taking advantage of irrational statements

Contrarian Investing

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