Think like a contrarian when it comes to your Investments

Turn on the TV or radio and you are immediately transported to the oil spill in the Gulf of Mexico. For savvy investors, this type of a disaster and others like it may be an opportunity to profit. While it may seem a bit crass to try and profit when the birds and fish are dying – and previously pristine, white beaches are now covered in oil – smart investors lick their chops when such disasters strike.

Why they are pleased

Why? Because in the case of BP, they focus not solely on the damage caused by BP, but rather on the damage caused to BP’s stock and bond price. This is not a suggestion that you buy BP shares, but it’s a great example of what is termed “contrarian” investing. Investors who go against the general market trend are called “contrarians”.

Contrarian

A contrarian is defined as an individual who believes that certain crowd behavior among investors can lead to exploitable mispricings in the securities markets. For example, widespread pessimism about a stock can drive its price so low that it overstates the company’s risks and understates its prospects for returning to profitability.

BP

A contrarian investor would make the case that BP is the fourth most profitable company in the world, and it has already lost more than half of its value. In addition, a contrarian would assess that even the worst-case scenario would mean that the company’s litigation exposure and clean-up costs would come to maybe two or three years of its operating income. And no one expects the company to pay up immediately; much of the litigation exposure will be tied up in the courts for years. It was 19 years after the Exxon Valdez oil spill until the Supreme Court made a final ruling regarding Exxon’s legal liabilities. This is not a recommendation to buy the stock – it’s just a good example to explain the concept.

Distressed stocks

Identifying and purchasing distressed stocks and selling them after the company recovers can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out.

Backward thinking?

What about the risk?

Some investors do have an inverted perception of risk. They tend to buy stocks when they have already appreciated significantly and sell them after they have already gotten crushed. However, this is the opposite of the golden rule of investing: Buy low and sell high.

Baron Rothschild

Baron Rothschild, a member of the Rothschild banking family, is credited with saying: “The time to buy is when there’s blood in the streets, even if the blood is your own.” This motto has served shrewd investors for decades. The most famous of all investors, Warren Buffet said: “You pay a very high price in the stock market for a cheery consensus.” In other words, if everyone is in agreement about a particular investment, it may not be a good one.

An Easily Understandable Explanation of Derivative Markets

Drink now, pay later
Word gets around about Heidi’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Heidi’s bar. Soon she has the largest sales volume for any bar in Detroit.

Price increases
By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi’s gross sales volume increases massively.

The bank
A young and dynamic Vice President at the local bank recognizes that these customer debts constitute valuable future assets, and increases Heidi’s borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral. At the bank’s corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These Securities are then bundled and traded on international security markets.

Investors
Naive investors don’t really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

Risk manager
One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. He so informs Heidi.

Demand for payment
Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Heidi cannot fulfill her loan obligations, she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Collapse
Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

Securities
The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various BOND securities. They find they are now faced with not only having to write off her bad debt but also with losing over 90% of the presumed value of the bonds. Her wine supplier claims bankruptcy, closing the doors on a family business that had endured for three generations, and her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Bail out
Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar, no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi’s bar.

How well have stocks done over 109 years?

Tracking results from 1900
In the case of the stock market, the sample should be taken over as long a period as possible. Three British economists tracked share prices in 17 markets from the start of 1900 to date. The markets they covered constituted 90% of the global trade in stocks, in terms of market capitalization during the last 109 years, 1900 to 2008. The database has full information about every price of every share in all these 17 markets, as well as data on dividends. Using their data, the economists calculated the returns in each of the markets for each of the 109 years, and the returns of a “global index” in each of the 17 markets.

Crisis years
During the last 109 years, there were six shattering, protracted crises. Two of them were in the last decade. Two other crises were world wars. The data shows that the wars’ effect on equities was relatively small compared with the crises of pure economic origin. Moreover, when trouble arrives, different markets fall by different degrees. During the Great Depression from 1929 to 1931, the global index of the 17 markets fell by 54%. But the real drop in the U.S. market was far greater, 79%. More recently, we find the great technology crash of the new millennium. From 2000 to 2003, the global index of stocks fell by 44%, but Germany’s stock exchange fell by 65%.

The current crisis
In the current crisis, the global index of shares fell 54% in real terms. This time the stock market that suffered the most was Ireland’s, which fell 70%. The conclusion is that even when markets seem to be striding in tandem, there are actually great differences among them.

The 109 year picture
Seen over 109 years, the global index of shares generated returns of 5.2% a year, after adjusting for inflation. The previous reading, taken at the end of 2005, found that the global index of shares had returned 5.8% a year. We can generalize and say that over more than 100 years, stocks returned 5% to 6% a year. That’s very high compared with returns on government bonds, which in the last 100 years returned something under 2%.

Another lesson
Another lesson from these figures is that in the investment world, 10 years is not a long time. Even during the 19 years from 1990 to 2008, investors received real returns of 1.8%, which paid them no better than government bonds.