It is tempting to copy the viewpoints of other investors. For example, during a bull market you may become excessively optimistic about the stock market's prospects due to upbeat sentiment among your peers.
However, following the market can lead to inefficient portfolio management. It may mean that you buy stocks at high prices and miss out on opportunities to purchase them at low prices during a bear market.
Oaktree Capital cofounder Howard Marks (Trades, Portfolio) has always sought to ignore his peers when allocating capital. His contrarian stance may be a key reason for his long-term outperformance of the stock market.
An independent viewpoint
Contrarian investing does not necessarily mean that you go against the market crowd at every opportunity. However, it does mean that you focus on facts and figures to make up your own mind up about a company's prospects.
This can mean that you underperform other investors in the short run. Market trends can persist even when they have reached points that cannot be sustained. For instance, stocks can move from being overvalued in a bull market to trading at prices that are even more excessive.
However, in the long run, having an independent viewpoint on a company's prospects may improve the efficiency of your capital allocation. It may enable you to more easily find undervalued stocks, and avoid those businesses that offer unfavorable risk/reward investing opportunities.
As Marks once said, "We must strive to understand the implications of what's going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into action or panic selling, we should become aggressive."
Preparing for change
Adopting a contrarian position can allow you to prepare for a likely change in the stock market's performance. No bull market or bear market has ever lasted forever. Therefore, using company fundamentals to take a contrarian position may mean that you benefit from an eventual change in the stock market's performance.
This does not mean that you try to predict the stock market's future outlook, or that you try to time the market. Instead, it could mean that your portfolio contains only companies that trade at or below their intrinsic values. Likewise, you may decide to only invest in those businesses that have sufficient financial strength to overcome the current uncertain economic period.
This is likely to mean that you are in a stronger position when the current bull market comes to an end and the next bear market commences. As Marks once said, "You can't predict. You can prepare."
Identifying industry mispricings
In my view, there always mispriced stocks available to buy. For instance, the stock market's recent gains have been partly driven by growth among large-cap technology companies. However, outside of that sphere, many stocks trade at relatively low prices due to weak investor sentiment.
Contrarian investors may be able to more easily take advantage of mispricings within a specific industry than their peers. For example, they may capitalize on weak sentiment towards a struggling sector that means businesses with sound finances and wide economic moats trade below their intrinsic values.
Marks has always sought to identify stocks that trade at unjustly low prices. As he previously said, "Inefficiencies – mispricings, misperceptions, mistakes that other people make – provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes."
Read more here:
- Charlie Munger: Self-Discipline Is Crucial to Investment Success
- Warren Buffett on What Makes a Successful Value Investor
- Joel Greenblatt on Managing Your Portfolio in a Bull Market
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