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Different investors take their own approach to choosing stocks, from believing that “fashion is your friend”, to go against the prevailing wisdom. The latter approach is known as contrarian investing: acting in a way that goes against what the majority of investors are doing.
In recent days some stocks have plummeted. That’s most obvious in the US banking industry, but there are plenty of examples elsewhere. Contrarian investing suggests buying cheap stocks when sellers are unloading them and then holding on to get them back. As billionaire investor Warren Buffett says, “be greedy when others are fearful”.
Could now be the time for an investor like me to try to profit using this contrarian approach?
Buffett and the reverse investment
Could be. The basic idea behind contrarian investing is the same one that underpins many investment strategies. That the market in general sometimes fails to assess the intrinsic value of a business. Buffett has occasionally made large profits on the contrarian investment.
The salad oil scandal of the 1960s (in which loans were made based on non-existent salad oil as collateral) slashed the market valuations of financial services companies, including amexpress. But Buffett correctly calculated that Amex would see little business impact, so his stock was a bargain. He built a stake in his company Berkshire Hathaway still owns today.
Buffett invested 5,000 million dollars in Goldman Sachs in the midst of the 2008 financial crisis. That led to a multimillion-dollar profit for the ‘Sage of Omaha.’
Focus on company valuations.
However, the opposite reversal can sometimes be a disastrous mistake. The crowd may be smarter than individual investors realize.
Sometimes what pushes a stock price down to what appear to be bargain levels can become such a problem that the company collapses. That’s what happened to construction giant Carillion, for example.
At other times, the deterioration of investor confidence can itself change the underlying economics of a company. A fairly healthy business may suddenly find suppliers withdraw credit terms and demand cash on delivery, changing their outlook overnight.
A successful investment involves evaluating the value of a business and buying below that price. When events are moving quickly, it may be impossible to accurately assess that value.
Yesterday, some midsize US banks saw their share prices plummet and soar in a matter of hours. But since the outcome of the current banking crisis is unclear, I think it’s simply impossible to make an assessment of the likely future value of some of those banks with any degree of confidence.
avoiding speculation
Therefore, I view buying such stocks at this time not as a contrarian investment, but as speculation.
As a long-term investor, I look to buy and hold shares in large companies that I believe are attractively priced. Sometimes that goes with the crowd, like when I bought Apple a few years ago. At other times, it may be the opposite, like my decision last year to buy super dry.
Such a contrarian investment has yet to fit into my overall investment strategy of buying what I believe to be great deals on the cheap.
If I can’t assess the value of a business, I can’t make informed investment decisions about it either. For many stocks, I think now is definitely not the perfect time to take a contrarian approach.
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