Contrarian investors are often ridiculed by the rest of the investment community for their stubborn, illogical view on the stock market. When everyone else is running for the sidelines, contrarians are buying and when the rest of Wall Street is bidding up everything with a ticker symbol, contrarians are yelling Sell, Sell, Sell! As unreasonable as that behavior might seem, one has to ask what is logical about the mainstream viewpoint. Is it logical that a stock should become a better purchase as it becomes more expensive? Would you use that model to buy a car or a house?

In this paper, we take a look at the stubborn contrarian and compare his viewpoint to conventional investing methods. We also discuss contrarian strategies for investing in small capitalization companies.

CONTRARIAN STRATEGIES DEFINED

Those who follow contrarian investing strategies believe they bring much needed rationality to the otherwise emotional and temperamental market. To prove the rationality of their strategies, contrarians simply point to their success. For example, economists Werner DeBondt and Richard Thaler showed in a recent study that contrarian strategies that buy stocks with low long-term returns and sell those with high returns earn abnormal profits over a holding period ranging from three to five years. (1) Additionally, several recent papers have demonstrated that long-term contrarian strategies are not significantly riskier than average. (2)

Unfortunately, other than arguing that they are the most rational of investors, contrarians appear to have little agreement in defining their strategies. All contrarians believe they are true follows of the age old investment philosophy of "buying low and selling high." However, just how they identify low and high is open to considerable discussion.

CONTRARIANS PAST AND PRESENT

When asked how he became so wealthy, Meyer Rothschild, a German banker and patriarch of the legendary House of Rothschild, attributed his success to buying when "there was blood in the streets." The eminent financier said he waited for real panic to manifest before he moved. For the elder Rothschild, who lived through the Napoleonic wars, his reference to blood may have been as literal as it was figurative.

Thankfully, contrarian principals apply even without bodily harm. One quite famous and much more contemporary contrarian is Warren Buffet, founder of the Berkshire Hathaway investment company. Buffet is a "marshmallow" in comparison to Rothschild, but his success is no less impressive. Buffet has guided his fund to the highest share price in the U.S. stock market by looking for dividends among out of favor stocks. He has opined that he does not believe in the price/earnings multiple. Interestingly, Berkshire shares trade among the highest price/earnings multiples in the market, bid up by the cult-like following Buffet has accumulated.

George Soros, currently chairman of Soros Fund Management, LLC, is another closely-watched investor. Soros does not consider himself a contrarian investor, but his track record suggests he has a penchant for betting against the market. In 1970, Soros started the Quantum Fund with Jim Rogers, a contrarian investor-philosopher from Hungary. Soros is famous for going short the British pound and earning $1 billion in a single day in 1992, now known as Britain's Black Wednesday.

Anyone interested in the contrarian viewpoint might find Jim Rogers' book, Adventure Capitalist - The Ultimate Investor's Road Trip, an interesting read. Rogers, who always wore a bow tie at the office, based the book on his casual drive through a hundred-plus countries around the world between 2000 and 2003. The book is not a fast read, but Rogers tosses aside conventional thinking and gives a thumbs-down to investing in Russia and India. Instead, he picks China, Uruguay and Mongolia as preferred alternatives.

The Less-Than-Famous- or Astonishingly-Rich

Jim Rogers can afford to thumb his nose at convention. He started out as an immigrant with a few hundred dollars in his pocket and retired in his late thirties with billions. Not every contrarian investor becomes so wildly wealthy, but they do meet with success. For example, we found two online advisors for individuals, InvestmentU.com and GetFolio.com, which both tout strong performance track records that beat market benchmarks.

The number of contrarian funds proliferated in the U.S. in the mid-1990s. In 1996, Carl Marker, founder of IMS Capital Management, launched his own no-load mutual fund. Marker positioned the IMS Capital Value Fund as a value-oriented, contrarian fund focusing on Fortune 500 companies. Likewise Robertson Stephens started its Contrarian Fund in the mid-1990s. The popularity of the approach has not waned. Nor is it limited to U.S. funds. Tata Mutual Funds based in Mumbai, India launched their Tata Contra Fund in July 2005. They plan to invest in fundamentally strong companies using a contrarian approach to stock selection.

Lighthouse Opportunity Fund, which is managed by Lighthouse Capital in Houston, was once known as Lighthouse Contrarian Fund but the managers found that the word "contrarian" is commonly misinterpreted or is unfamiliar to investors. It was a change in name only and the fund managers continue to use what they describe as "contrarian thinking" by "looking in areas out of favor with the investing public." The fund still invests in undervalued companies that are technically aggressive, fiscally conservative and globally competitive.

Nonetheless, we found a number of funds using contrarian management strategies and not afraid to make it known. David Decker manages the Janus Contrarian Fund by investing "where others are not." Since inception in 2000, the fund has earned 8.1%. The Intrepid Contrarian Fund of industry giant JP Morgan has been a little more successful in its two-year history, returning just over 20% after sales charges.

CONTRARIAN STRATEGIES TO SELECT SMALL-CAP STOCKS

Widely accepted thinking in the capital markets is the Efficient Market Hypothesis, which holds that the market prices of public companies are reflective of all information and are therefore efficient representations of value. Security prices revert back to the mean as soon as public information becomes available.

We certainly do not disagree with the theory in principal. Yet we know that while the market may be perfect, communications and

Since complete information diffusion is reached at a much slower pace for the smaller company, we believe the contrarian investor has time in the small-cap sector to ply his "stubborn, illogical" style. Indeed, empirical evidence has shown that contrarian portfolio returns are stronger for firms which have a lower rate of information diffusion. One recent study using NYSE and AMEX listed securities found that the average return difference between contrarian portfolios in the smallest and the largest capitalization quintile stocks was 0.46% per month. (5)

Out of Favor Stocks

The contrarian is interested in stocks that the consensus does not wish to own. The stocks may appear relatively inexpensive based on a discount to its peer group or the market average. Harry Domash's stock selection service, WinningInvesting.com, uses the number of analysts' buy/sell ratings as an indicator of whether a stock is in or out of favor as an alternative to the traditional valuation ratios.

Capitalizing on Overreaction

Many investors believe the stock market consistently overreacts to new information, resulting in dramatic price reversals. Some contrarians believe they can make substantial profits in the short-term by buying the apparent losers and selling winners. Investors using this approach may find helpful the book Stock Market Overreaction and Fundamental Valuation by Matthias Kulpmann. The book investigates evidence of reversals in the cross section of stock returns. Kulpmann finds that reversals in stock returns are paralleled by movements in fundamentals.

Avoiding the Crowd

While Meyer Rothschild took advantage of the mistakes or misfortunes of the crowd, modern day contrarians find reward in simply avoiding the crowd. John Summa has written a moderately entertaining how-to book for such contrarians called Trading Against the Crowd - Profiting from Fear & Greed in Stock, Futures, and Options Markets. Summa puts crowd psychology to use in spelling out a variety of practical trading strategies such as Squeeze Play I and II, Tsunami Sentiment Wave, and the Fourth Estate. (The names are the entertaining part.)

The Art of Contrary Thinking by Humphrey Neill is another instructive volume on investor sentiment. Neill described "the crowd" as most enthusiastic and optimistic when it should be cautious and prudent and fearful when it should be bold. He uses the famous Tulipmania case in late 16th Century Holland as an example of what happens when everyone thinks alike, i.e. behaves according to the crowd. Neill advocates that the successful investor capitalizes on knowledge of crowd behavior.

Deep Value

Perhaps a company looks expensive to the rest of the market based on earnings or return on capital. Yet a contrarian finds the company inexpensive on an absolute basis, trading at a discount to private market value. The deep-value contrarian looks beyond the obvious to the root cause of earnings weakness to determine if it is temporary condition and likely to reverse.

CONCLUSION

The contrarian investment style is heavily dependent upon intensive research that goes beyond the summary data provided by financial services or developed internally by summarizing company reported financial information. Investigating a possible investment involves communicating directly with company management, suppliers and customers to determine the company's competitive position. Relative to other investment strategies, it may be time consuming to initiate a position. Yet where pricing inefficiencies correct more slowly, contrarian investors have the time to complete the investigation that others are unwilling to undertake. We believe this makes the contrarian's "stubborn and illogical" approach particularly effective in the small-cap sector.

Debra Fiakas, CFA

www.crystalequityresearch.com

NOTES

(1) De Bondt, Werner F.M., and Richard Thaler, "Further Evidence on Investor Over-reaction and Stock Market Seasonality," Journal of Finance, 1987. Vol. 42, pp. 557-581.

(2) Lakonishok, Joseph, Andrei Shleifer, and Robert Vishny, "Contrarian Investment, Extrapolation and Risk," Journal of Finance, 1994. Vol. 56, pp. 699-720.

MacKinlay, A. Craig, "Multifactor Models do not Explain Deviations from the CAPM," Journal of Financial Economics, 1995. Vol. 38, pp. 3-28.

Daniel, Kent D., "Evidence on the Characteristics of Cross-Sectional Variation in Stock Returns," Journal of Finance, 1997. Vol 52, pp. 1-33.

(3) Holden, Craig W., and Avandihar Subrahmanyam, "News Events, Information Acquisition, and Serial Correlation," Journal of Business, 2002. Vol. 75, pp. 247-270.

Foster, F.D. and S. Viswananthan, "The Effect of Public Information and Competition on Trading Volume and Price Volatility," Review of Financial Studies, 1993. Vol. 6, pp. 23-56.

(4) Brennan, Michael J., Narasimhan Jegadeesh, and Bhaskaran Swaminanthan, "Investment Analysis and the Adjustment of Stock Prices to Common Information," Review of Financial Studies, 1993. Vol. 6, pp. 799-824.

(5) Yalcin, Atakan. "Gradual Information Diffusion and Contrarian Strategies," Koc University, College of Administrative Sciences and Economics. February 2003.
About the Author

Debra Fiakas, CFA is a seasoned investment professional with a diversified and successful track record. Her decade-plus career includes experience in all aspects of the equity capital markets with particular emphasis on emerging growth companies . Ms. Fiakas is the managing member of Crystal Equity Research, a Registered Investment Advisor in the State of New York. Additional formation is available at the firm's web site at WWW.CRYSTALEQUITYRESEARCH.COM