Going against the crowd

Contrarian investing: Buy niche stocks ignored by consensus opinion

“If everybody else is doing it one way, there’s a good chance you can find your niche by going in exactly the opposite direction” Sam Walton.

A  contrarian investor is the one who attempts to profit by betting against the conventional wisdom, only when the consensus opinion appears to be wrong. What really differentiates contrarian investor is his emphasis on looking for opportunities where consensus opinion has led to miss pricing. When I say looking for mis-priced bets I mean that they are looking to exploit areas, where consensus opinion has led to an exaggeration of problem at hand. This exaggeration is often the result of mass psychology that is almost always prevalent in the stock market to varying degrees.

At the heart of the argument of betting against the crowd, when the consensus opinion appears to be wrong, is the belief that markets, which are more often than not efficient, sometimes err on the side of inefficiency. To understand this anomaly, it helps to think of the stock market as an aggregator, where people of diverse opinions, expectations and incentives, bet against each other leading to more or less efficient markets.
But sometimes, this diversity amongst its participants is broken down, due to factors like excessive fear or greed. It is at times like this that a contrarian investor starts to see a opportunity to bet against the crowd, if he has reason to believe that it is not the fundamentals but fear and greed that is driving the current markets.
 
Why contrarian investing is difficult

An investor’s aim is to profit by buying low and selling high based on fundamental and technical analysis. The act of comparing current price versus historic and prospective earnings of a company will classify one as fundamental analyst, which constitutes all the following variants on the theme – top-down approach, bottom-up, growth, value, country specific, and commodity. On the other hand, the act of comparing current price and volume patterns to the price and volume pattern from the past along with other factors, can be classified as technical analyst.

Among the fundamental analysts what is it that differentiates contrarian and value investors from the rest? It is psychological constraints and organisational constraints.
When an individual learns things on his own it helps get through our daily life, by making things easier to accomplish. But as an investor, these shortcuts can be detrimental to our investment performance by affecting the way we make decisions.
But the most important heuristics, which make practicing contrarian investing a difficult task to accomplish are as follows.

Group think:  One of the advantages of being an individual investor is that there is no pressure to sacrifice your own views to be a part of any group or to have people agree with you. It is a different thing that investors sometimes create their own groups, within friends or colleagues, and succumb to group thinking. Whereas when you belong to fund houses, the most common behavioural anomaly affecting them is ‘Group Think.’ They all think alike and even if they don’t agree with something, for the fear of being reprimanded in the group, they hide their true perspective about something.

False consensus effect: False consensus effect highlights the tendency common amongst us, where we over estimate the percentage of people we think would agree with us. As an investor, the decision we reach about an investment opportunity does not necessarily have to be in accordance with most other people.

Their motives for investing in stock market might be different, their philosophy might be totally different, their risk appetite might be different, and their expectation from business might be different than yours. The bottom line is to remind yourself of false consensus effect and weigh your decision based on the facts you have on hand and your reasoning. Don’t let other people’s perception affect you unless it points out to something wrong in your reasoning.

Buyer’s remorse:  It is a very common tendency amongst everybody to varying extent. After we commit our capital into anything, self doubt triggers a sort of remorse to the extent that have we done something wrong. In times like this, unless we have a deep conviction in our stand and are ready to face the uncertainty, it becomes very difficult to continue with our stand. It is also because many people would be hell bent on proving you wrong.

Thus deep-rooted conviction, leading to being patient with such an approach is key to following contrarian approach to investing. Illusion of control:  How many of us can say that we reached our present state by putting in effort towards this particular end? None of us, I suppose.

Chance plays a critical element in governing the exact outcome of our endeavours. Our job is to ensure that good work will eventually be rewarded in the long run.

The same applies to stock market investing. Yet it is common behaviour to note that people have a tendency to act as if they have everything under their control, especially when it comes to investing. We should not fool ourselves by believing that we have destiny under our control.

Herding:  As an investor, it is difficult to think out of the box and stand outside the pack for consistently longer periods of time. It requires an unflinching conviction in one’s belief and the ability to withstand being called a failure until the culmination of the struggle.

And contrarian investing requires one to be able to have attributes such as being patient along the periods of uncertainty before the final outcome, which could eventually prove one right. It is only normal behavior to observe people tend to converge towards an opinion, which forms the foundation of the conventional wisdom, irrespective of its validity. Moreover, the ability to withstand such social pressures and hold contradicting views should be considered as extraordinary behavior on the part of the individual.

Myopic loss aversion:  ‘If you cannot stand 50 per cent paper loss on your stock, stay away from the markets’ said Warren Buffet. Loss aversion says that people are more upset when they experience losses as compared to the satisfaction derived from a similar gain.  This tendency leads to a behavior where investors, faced with the prospect of temporary quotation loss, tend to forgo investing in such situations even if during the longer run such approach leads to higher returns. Since contrarian investing is for long term, the ability to withstand temporary losses is a necessity rather than an exception.

Recency effect:  While investing it may not be possible to consider too many things to reach a decision. The best way to go making a decision, under such physiological constraints, is to decide using the data that is readily available.

And more often than not, memory brings forth to fore the data that is recent. Unless one consciously puts in an effort to consider things from the past, it is only normal to fall into the trap of believing the recent past to be an appropriate representation of the ultimate reality.

To be a contrarian investor, one needs to have the ability to relate the present situation in the context of, not only the present or recent past, but go far into the past and put things in perspective.

Confirmation tap:  There is generally a lag between the action and desired outcome. And there is never a surety that a particular action would lead to a particular outcome.  
Under such circumstances, it is only natural to confirm our stance by seeking confirmation from the actions of other people. In the absence of such evidence and the inability to confirm our actions, one is left to face great uncertainty until the culmination of outcome.
But as a contrarian investor, one has to learn to stick and put to test his own views and stance, and this makes contrarian investing difficult to successfully implement.

Organisational constraints:  A vast pool of capital to be invested in capital markets take the route of institutions – mutual funds, private equities, Insurance companies, Pension Funds, NRIs, FIIs etc — where the investment decisions are taken under the purview of agendas set by the authorities looking after the interests of the institutions primarily and secondly, these agendas are followed by the individual asset managers, whose interest might not be in alignment with the stakeholders of the institutions.

The general areas of conflict of interest can be divided into two: between the institution and the segregated stakeholders and between the asset managers and the institutions.

Investment as a business:  The simple distinction between investment as a business and as a profession can be understood from the basic mode of profit seeking by the institution.

Does it earn a profit only when the unit holders in Mutual Funds make a profit? Or does it take a simple route of taking a big  portion of asset under management as management fee reaching as high 3-5 per cent of assets, every year, irrespective of its  performance.

Operating under such  incentives, the authorities might be more interested in attracting more capital under management than working towards making more money for the current stakeholders, particularly when it involves sitting on the sidelines and going against the conventional wisdom, which leads to temporary periods of looking foolish.

Source: Parag Parikh’s second book, Value Investing and Behavioral Finance - Insights into India Stock Market Realities