My first teacher on valuation, Professor Aswath Damodaran, calls himself a contrarian value investor in one of the video lectures I watched many years ago. Just like value investing, contrarian value investing comes in different shapes and sizes. Contrarian stocks could be hated, ignored, neglected or misunderstood.
I separate contrarian stocks into two distinct types.
The first type of contrarian stock is named after Hollow Man, a 2000 movie starring Kevin Bacon as a man who became invisible. Hollow Man stocks are typically microcaps with little or no analyst coverage and trading liquidity. Hedge funds cannot play in the microcap space because AUM size restricts them, and amateur investors are either unaware of their existence or are uncomfortable with the lack of newsflow and coverage. In a quantitative sense, they are typically identified by their narrow valuation ranges, till they are discovered.
The second type of contrarian stock is called the Fallen Angel. Fallen Angel stocks are either growth stocks with decelerating growth or former market darlings suffering from a major negative event. They usually have experienced a share price drop in recent months or have reached a new historical low after a prolonged period of weakened share price performance. The key to investing in such fallen angels is to determine if the decline is temporary or secular. If the fallen angel has transformed from a growth stock to a cash cow, its policy of dividends and share repurchases is critical.
According to a 2004 Brandes Institute study titled "Falling Knives Around the World," the average U.S. falling knife outperformed the S&P 500 substantially gained an annualized 11.2% over the three years following its initial fall, while the corresponding gain for the S&P 500 averaged only 4.6%. Falling knives were defined as stocks whose prices declined 60% or more over a 12-month period, and the period of study was from 1980 through the end of 2003. It is worth noting that the results of the study showed that enterprise-value-to-sales ratios could help investors identify the most compelling opportunities among falling knives.