Curated Portfolio | XC Quant: Contrarian

By Hardik Nigam (hardik.nigam.23i@jaipuria.ac.in)

A contrarian investment strategy involves selling when others are buying and buying when others are selling in order to go against the general trend of the market. When individuals claim the market is going higher, contrarian investors think it’s because they’re already all in and can’t afford to buy more.

If the market is now at its highest point, this means that the market can only move up if individuals forecast a decline since they’ve already sold out. Taking a contrarian perspective of the market and doing the legwork to see whether there’s a profitable investment opportunity is the agenda of this blog. For their bets to pay off, contrarian investors need to be ready to put in a lot of time studying the market.

A contrarian investor can be pessimistic and hunt for selling opportunities while the market is bullish. In contrast, a contrarian investor would be positive if the market was negative and would seek for buying opportunities.

Overreacting to news events and overpricing “hot” companies while underestimating the earnings potential of distressed businesses are two of the worst mistakes investors make, according to contrarian investor and author David Dreman in Contrarian Investment Strategies: The Next Generation.

In financial markets, the herd mentality almost usually triumphs. Contrarian investors may profit from this overreaction, which results in restricted upward price movement and sharp declines for “hot” equities. Buffett’s famous quote, “Be wary when others are greedy, and greedy when others are greedy,” perfectly captures the idea.

Our Portfolio

In the Indian market, a contrarian investment strategy we used has produced significant average excess returns. This strategy is known as “XC Quant: Contrarians.” Over the course of ten years, from 2012 to 2022, this approach was backtested using a universe of more than 500 companies.

This approach would have outperformed the NSE 500 by a significant margin, exceeding it with a CAGR of 38.51% as opposed to just 14.91% for the same time period.

This indicates that a portfolio including these companies are not just undervalued but are also capable of making money along the path. The graph below also shows this clear outperformance.

XC QUANT: CONTRARIAN VS BENCHMARK [NSE 500 CUMULATIVE RETURNS (LOG-SCALED)]

Additionally, the graph below demonstrates how much the XC Quant: Contrarian portfolio has beaten the NSE 500. In 81.82 percent of the one-year periods, the XC Quant: Contrarians beat the NSE 500, demonstrating its significant outperformance.

Summary of Quintile Performance in last 10 years

Average Excess Return vs Benchmark

The table and chart above reveal that when stocks are divided into quintiles according to the contrarian strategy we are using, the top two quintiles perform the best and the performance of the portfolios gradually declines, showing that the top quintiles contain undervalued stocks that are beaten up by investors but have the potential to grow in the future.

Sharpe Ratio of different quintiles

Similarly, the Sharpe Ratio of the top two quintiles is best before gradually declining in other quintiles. This shows that the top two quintiles have the best return per unit of risk. In none of the quintiles did the benchmark (NSE 500) ever beat the portfolio. The NSE 500 barely made it to the fifth quintile.

Contrarian Investing: How Does It Work?

To become a contrarian investor, one must first get a deep understanding of the common opinion on a certain subject. A particular stock, a section of the stock market, or the whole market might be affected by this. Once they’ve poked flaws in that belief, a contrarian investor comes up with an argument to support their own.

A contrarian investor may, for example, develop a “bear case” for the stock market, or for a specific sector within it, if the prevailing opinion is that the economy is accelerating.

When the market consensus is gloomy, a contrarian investor may find himself positive. This is especially true for out-of-favor stocks or sectors of the stock market. Investors combine their money into hedge funds, which often pursue aggressive contrarian investing strategies.

Investors that take a contrarian approach aren’t focused on the near term. By identifying areas in the market where they feel that the prevailing perspective is incorrect, they hope that their investment will pay off when other investors modify their views.

Consistent with their anti-contrarian philosophy, contrarian investors must accept the risk of short-term losses and uncertainty to be successful.

Benefits of Taking a Contrarian Approach to Investing

There are two main reasons why contrarian investment is intriguing. This may help contrarian investors uncover opportunities when the herd mindset is incorrect and perhaps outperform other investors.

With time and willingness to wait out their contrarian prognosis, contrarian investors may reap large rewards. A common contrarian technique is to buy in equities during a bear market, or when stock values are declining. For example

Although contrarians may not be able to predict exactly when the market will hit its bottom, they may still profit from their investment by purchasing when other investors are racing to sell.

As a last thought, being involved as a contrarian may provide enormous personal gratification to those who are inclined to think otherwise. Aside from the financial advantages, investors may find this kind of investing enjoyable since it demands a lot of study and market knowledge, particularly when their prognosis is true.

Contrarian Investing has its drawbacks.

Learning to be a contrarian investor involves a lot of curiosity and self-motivated study time to learn about how different companies, industries, and even the market as a whole are traded.

This degree of fortitude requires contrarian investors who must wait a long time to determine whether their idea is accurate. This level of fortitude requires contrarian investors due to the potential for short-term underperformance in pursuit of their contrarian approach paying off, contrarian investors must have both the time and the money to hold out.

Investing in a contrarian approach that may take months to bear fruit has an opportunity cost, and investors must be willing to accept this level of risk.

For most investors, contrarian investing is out of reach due to the amount of time and effort necessary to create good contrarian beliefs. Because of this, it’s difficult for contrarian strategies like this one to be successfully executed, even if they have enticing potential rewards.

Things to Keep in Mind

When a company’s stock price has recovered and other investors have begun to target it, contrarian investors often seek distressed equities and subsequently sell them. It is based on the belief that, “Herd mentality that can affect market direction is not a smart technique for investing.“

But if the overall positive feeling in the markets is correct, it might lead to losing out on profits if contrarians have already liquidated their holdings. The market’s pessimistic mood may keep a stock that is targeted by contrarians as an investment opportunity cheap.

Background

Behavioral bias during major market movements is thought to be a factor in the undervaluation of certain equities. A distorted view of the risks and rewards of a company’s prospects may cause stock prices to soar to extremes. Contrarian investment is similar to value investing in that it looks for firms whose shares are undervalued by the market.

Valuation Investing as Opposed to Contrarian Investing

To a degree, value and contrarian investors are the same in that they seek for businesses whose share price is lower than the company’s real worth. So long-term fundamentals aren’t reflected in short-term stock price changes by value investors, they typically feel that the market overreacts to both good and negative news.

Contrarian investment and value investing, according to many investors, blur the lines since both seek for discounted stocks to benefit from the present market emotion.

It’s feasible to tell a value company from a growth stock using financial measurements like book value or price-to-earnings ratio. However, a “contrarian” investor is also interested in indicators of “sentiment” about the stock among other investors, such as sell-side analyst coverage and earnings estimates, trading volume and media commentary on the firm and its business prospects.

The “margin of safety” sought by value investor Benjamin Graham when acquiring stocks may be shown in the example of a company that has fallen due to excessive pessimism — essentially, the ability to acquire shares at a discount to their underlying worth. When a stock has dropped significantly, it’s more probable that this safety margin will exist, and a decline of this magnitude is frequently followed by bad news and overall pessimism.

Examples of Some Famous Contrarian Investors

  1. Warren Buffett — He is the most well-known contrarian investor. Investors should purchase American equities during the 2008 financial crisis, according to Warren Buffett, who advised them to do so at the time. The investment firm Goldman Sachs Group, Inc. was one of the businesses he bought stock in (GS). His suggestion was right ten years later. Goldman’s shares rose by 239 percent between 2008 and 2018.
  2. Michael Burry — As a neuroscientist turned hedge fund manager, He is yet another example of a contrarian investor. In 2005, Burry discovered that the subprime market was overpriced and inflated, based on his study. In shorting the most risky areas of the subprime mortgage market, his hedge company Scion Capital made a profit. Author Michael Lewis has turned his experience into a book called The Big Short, which has been converted into a film called The Big Short as well.
  3. John Templeton — A prominent contrarian investor, who was known for his unconventional investments. At the time of the fund’s creation, a $10,000 investment was worth $2 million when dividends were reinvested.
  4. John Maynard Keynes — While managing King’s College’s endowment from the 1920s through the 1940s, economist John Maynard Keynes was an early contrarian investor. A pioneer of institutional investing in common stocks and foreign equities, Keynes was the first university endowment to diversify its holdings beyond land and fixed-income securities. An investment approach similar but created independently the value investing paradigm of Benjamin Graham and Charles Dodd beat the UK market on average by more than 6%.

Limitations of this approach

Investors considering a contrarian approach to investing should be aware of the strategy’s shortcomings. Finding inexpensive stocks may be difficult, and contrarian investors often expend a significant amount of time examining different businesses and sectors in search of investing possibilities. It will not enough to just do the opposite of what the market is saying. For contrarians, mastering the fundamentals of analysis is critical to properly determining a security’s underlying worth.

It is possible for contrarians to have periods of underperformance in their investments. However, the contrarian investor may have to bear losses in the form of paper losses in the meantime.

IMPORTANT LESSONS TO LEARN

  1. A method of making money by defying the current tendencies of the market.
  2. There are times when markets are overpriced or undervalued due to herding tendency, which is exacerbated by fear and greed.
  3. If you’re a contrarian, you’re looking to acquire stocks that are presently undervalued.
  4. Being a contrarian may be beneficial, but it is a hazardous approach that may take a long time to yield dividends.
  5. As a contrarian investor, you’ll have to spend a lot of time scouring the stock market for discounted prospects.

Conclusion

The contrarian approach is to invest in equities that seem to be underperforming while the market’s mood remains pessimistic about their performance. For contrarians, this is an ideal entry point since it allows them to join at a time when the market’s direction may be changing. Often likened to contrarian investors, Warren Buffet’s comment, “Be afraid when investors are greedy and greedy when they are scared,” is a typical contrarian stance.

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References

  1. Dreman, D. (1999). Contrarian Investment Strategies: Beat the market by going against the crowd. Simon & Schuster.
  2. Tortoriello, R. (2009). Quantitative strategies for achieving alpha. McGraw Hill.
  3. Damodaran, A. (2006). Investment fables: Exposing the myths of “Can’t miss” investment strategies. Pearson Education.
  4. https://www.investopedia.com/terms/c/contrarian.asp#:~:text=Contrarian%20investing%20is%20an%20investment%20strategy%20that%20involves%20bucking%20against,markets%20periodically%20over%2D%20and%20underpriced.
  5. https://www.angelone.in/knowledge-center/share-market/contrarian

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Xumit Capital

Xumit Capital is a boutique investment advisory firm that deals in equity, global & crypto portfolios and investment migration programs.