Aswath Damodaran has an interesting blog post up on contrarian investing, and how investors can intelligently evaluate such opportunities.Damodaran divides contrarian strategies into four broad categories:
1. The Biggest Losers
An of contrarian investors is that people overreact to bad news, and that markets will eventually correct. If that’s your thesis, the stocks that take the biggest loss will have the greatest return. But keep in mind:
- Transaction costs; cheap stocks can have higher associated costs. Further, returns may be skewed by a few massive outperformers.
- Its all about timing. Watch for tax loss selling in December.
- Thing about the time horizon, the hoped for correction could take a very long time.
2. Collateral Damage
When there’s bad news for a country or sector, investors occasionally punish everybody. To profit from this, look for:
- Companies in troubled emerging markets that have high foreign sales (think Embraer in early 2000’s Brazil)
- Within sectors, focus on companies that are less exposed to the negative catalyst. Think banks with less prop. trading profit in the event of a strong Volcker Rule.
3. Comeback Bet
This involves taking a closer look at the drivers of a stocks decline; if there are deep, intractable problems, a stock is unlikely to recover. But if something causes a stock to drop below its true value, that’s an opportunity. Before taking that bet, ask yourself these questions:
- Is it a one time event?
- Is it fixable at all, or within a reasonable time frame?
- Is the decline in market value disproportionate?
4. Long Odds
This is the play when things get really bad somewhere. The floor for equities is zero, so when something gets pushed very low why not take a flier? To make a big profit you need a significant increase in value from an acquisition, new product, or market shift. You’re looking for a company that:
- Has some kind of proprietary tech or licence.
- Operates in a changing and risky business.
Read the whole post at Musings on Markets