OLD ARTICLE – Original posted on January 29, 2013
Value investing is a process of identifying potential investments that can be bought for less than they are actually worth. This is done via the valuation process. Once an undervalued investment is identified and it meets the criteria the investor is looking for, it is bought and then held until such a time as it’s market price (hopefully) rises to where it should be (i.e. fair value).
Basically, value investing is bargain hunting.
On the other hand, contrarian investing is simply buying what everybody is selling or selling what everybody is buying. In other words, a contrarian investor’s actions are contrary to the popular views in the market.
Basically, contrarian investing is “negative momentum trading” with, perhaps, a longer term time horizon than your average trader.
Many people mistake contrarian investing for value investing and visa versa.
This is a mistake, as they are actually completely different.
The market has a habit of over-reacting. Thus often a company that has disappointed sees its share price aggressively sold down in the market. The market’s over-reaction may drive this share price down to such a level that it offers a value. Also, as the share is “out of favour” with the market, it would start to appeal to contrarian investors.
In this case, both value investors and contrarian investors may be buying the stock. Albeit, they would be buying the stock for very different reasons.
Now, say another company is growing at a fantastic and sustainable rate, year on year. This company’s prospects are rosy and the market knows this. Typically, the market would be buying the company’s shares, driving up the share price. But, perhaps the market has not fully understood just how good the prospects of the company are and, despite the run in the share price, is still under-pricing the shares against its risk-adjusted discounted free cash flows? Well, in this case a value investor would also be buying the stock. But, as this stock is obvious “in favour” with the market and has risen – probably exponentially – a contrarian investor would shy away.
In this case, a value investor could quite easily still buy into a stock that has risen, while a contrarian would avoid it.
In other words, contrarian’s buy into negative momentum, while value investors buy into the gaps between valuations and share prices.
This is a very, very important distinction, as many (including some major fund managers!) who view themselves as “astute value investors”, are in fact “reverse reactionaries” to market trends. If a company is doing well, they will find faults with it. If a share price is dropping, they will convince themselves that there simply must be value in it at these levels.
While there is nothing wrong with trading negative momentum like contrarian investors do (if that’s what you are into), not realizing that you are in fact doing so is quite dangerous. It may well lead to many of your positions being nothing more than catching the proverbial “falling pianos”.
The risk with contrarian investing is buying into “value traps” (What is a “value trap”?), while the risk for value investing include those limitations affecting traditional valuation methodologies and value-unlocking event risk.
So, both styles have risk(s)…
Are you a value investor or a contrarian? Think about it, conclude on it and then stick to it. After all, the greatest sin in the stock market is that of “style drift“.