Different investors take their own approach to choosing shares, from believing that “the trend is your friend”, to going against prevailing wisdom. The latter approach is known as contrarian investing – acting in a way that goes against what most investors are doing.
In recent days some shares have plummeted. That is most obvious in the US banking sector, but there are many examples elsewhere. Contrarian investing suggests buying shares cheaply when sellers are dumping them and then holding them for recovery. As billionaire investor Warren Buffett says, “be greedy when others are fearful”.
Could now be the moment for an investor like me to try and profit by using this contrarian approach?
Buffett and contrarian investing
It might be. The basic idea that drives contrarian investing is the same one that underpins a lot of investment strategies. That the market overall sometimes fails to assess the intrinsic value of a business. Buffett has occasionally made huge returns from contrarian investing.
The Salad Oil Scandal of the 1960s (in which loans were made based on non-existent salad oil as security) pushed down the market valuations of financial services firms dramatically, including American Express. But Buffett rightly reckoned that Amex would see little business impact so its shares were a bargain. He built up a stake his company Berkshire Hathaway still owns today.
Buffett invested $5bn in Goldman Sachs in the midst of the 2008 financial crisis. That led to a multibillion dollar profit for the ‘Sage of Omaha’.
Focus on business valuations
However, contrarian investing can sometimes be a disastrous mistake. The crowd may be smarter than individual investors realise.
Sometimes, the thing that pushes down a share price to what seems like bargain levels can actually turn out to be such a big problem that the company collapses. That is what happened to construction giant Carillion, for example.
At other times, souring investor confidence can itself change the underlying economics of a business. A fairly healthy business can suddenly find that suppliers withdraw credit terms and demand cash on delivery, changing its outlook overnight.
Successful investing involves assessing the value of a business and buying below that price. When events are fast-moving, it can be impossible to assess that value accurately.
Yesterday, some medium-sized US banks saw their share prices crash and soar within hours. But with the outcome of the current banking crisis unclear, I think it is simply impossible to make an assessment of some of those banks’ likely future value with any degree of confidence.
Avoiding speculation
I therefore see buying such shares right now not as contrarian investing, but as speculation.
As a long-term investor, I look to buy and hold shares in great businesses that I think are attractively priced. Sometimes that is going with the crowd, as when I bought Apple a few years back. At other times, it may be contrarian, like my decision last year to buy into Superdry.
Such contrarian investing still needs to fit into my overall investment strategy of buying what I think are great businesses on the cheap.
If I cannot assess the value of a business, I also cannot make informed investment decisions about it. For a lot of shares, I therefore think now is definitely not the perfect moment for me to take a contrarian approach.
