Contrarian Strategies: Selecting Small Capitalization Stocks

INTRODUCTION
Contrarian investors are often ridiculed by the rest of the
investment community for their stubborn, illogical view on the
stock market When everyone else is running for the sidelines,
contrarians are buying and when the rest of Wall Street is
bidding up everything with a ticker symbol, contrarians are
yelling Sell, Sell, Sell! As unreasonable as that behavior might
seem, one has to ask what is logical about the mainstream
viewpoint Is it logical that a stock should become a better
purchase as it becomes more expensive? Would you use that model
to buy a car or a house?
In this paper, we take a look at the stubborn contrarian and
compare his viewpoint to conventional investing methods We also
discuss contrarian strategies for investing in small
capitalization companies
CONTRARIAN STRATEGIES DEFINED
Those who follow contrarian investing strategies believe they
bring much needed rationality to the otherwise emotional and
temperamental market To prove the rationality of their
strategies, contrarians simply point to their success For
example, economists Werner DeBondt and Richard Thaler showed in
a recent study that contrarian strategies that buy stocks with
low long-term returns and sell those with high returns earn
abnormal profits over a holding period ranging from three to
five years (1) Additionally, several recent papers have
demonstrated that long-term contrarian strategies are not
significantly riskier than average (2)
Unfortunately, other than arguing that they are the most
rational of investors, contrarians appear to have little
agreement in defining their strategies All contrarians believe
they are true follows of the age old investment philosophy of
“buying low and selling high” However, just how they identify
low and high is open to considerable discussion
CONTRARIANS PAST AND PRESENT
When asked how he became so wealthy, Meyer Rothschild, a German
banker and patriarch of the legendary House of Rothschild,
attributed his success to buying when “there was blood in the
streets” The eminent financier said he waited for real panic to
manifest before he moved For the elder Rothschild, who lived
through the Napoleonic wars, his reference to blood may have
been as literal as it was figurative
Thankfully, contrarian principals apply even without bodily
harm One quite famous and much more contemporary contrarian is
Warren Buffet, founder of the Berkshire Hathaway investment
company Buffet is a “marshmallow” in comparison to Rothschild,
but his success is no less impressive Buffet has guided his
fund to the highest share price in the US stock market by
looking for dividends among out of favor stocks He has opined
that he does not believe in the price/earnings multiple
Interestingly, Berkshire shares trade among the highest
price/earnings multiples in the market, bid up by the cult-like
following Buffet has accumulated
George Soros, currently chairman of Soros Fund Management, LLC,
is another closely-watched investor Soros does not consider
himself a contrarian investor, but his track record suggests he
has a penchant for betting against the market In 1970, Soros
started the Quantum Fund with Jim Rogers, a contrarian
investor-philosopher from Hungary Soros is famous for going
short the British pound and earning $1 billion in a single day
in 1992, now known as Britain’s Black Wednesday
Anyone interested in the contrarian viewpoint might find Jim
Rogers’ book, Adventure Capitalist – The Ultimate Investor’s
Road Trip, an interesting read Rogers, who always wore a bow
tie at the office, based the book on his casual drive through a
hundred-plus countries around the world between 2000 and 2003
The book is not a fast read, but Rogers tosses aside
conventional thinking and gives a thumbs-down to investing in
Russia and India Instead, he picks China, Uruguay and Mongolia
as preferred alternatives
The Less-Than-Famous- or Astonishingly-Rich
Jim Rogers can afford to thumb his nose at convention He
started out as an immigrant with a few hundred dollars in his
pocket and retired in his late thirties with billions Not every
contrarian investor becomes so wildly wealthy, but they do meet
with success For example, we found two online advisors for
individuals, InvestmentUcom and GetFoliocom, which both tout
strong performance track records that beat market benchmarks
The number of contrarian funds proliferated in the US in the
mid-1990s In 1996, Carl Marker, founder of IMS Capital
Management, launched his own no-load mutual fund Marker
positioned the IMS Capital Value Fund as a value-oriented,
contrarian fund focusing on Fortune 500 companies Likewise
Robertson Stephens started its Contrarian Fund in the mid-1990s
The popularity of the approach has not waned Nor is it limited
to US funds Tata Mutual Funds based in Mumbai, India launched
their Tata Contra Fund in July 2005 They plan to invest in
fundamentally strong companies using a contrarian approach to
stock selection
Lighthouse Opportunity Fund, which is managed by Lighthouse
Capital in Houston, was once known as Lighthouse Contrarian Fund
but the managers found that the word “contrarian” is commonly
misinterpreted or is unfamiliar to investors It was a change in
name only and the fund managers continue to use what they
describe as “contrarian thinking” by “looking in areas out of
favor with the investing public” The fund still invests in
undervalued companies that are technically aggressive, fiscally
conservative and globally competitive
Nonetheless, we found a number of funds using contrarian
management strategies and not afraid to make it known David
Decker manages the Janus Contrarian Fund by investing “where
others are not” Since inception in 2000, the fund has earned
81% The Intrepid Contrarian Fund of industry giant JP Morgan
has been a little more successful in its two-year history,
returning just over 20% after sales charges
CONTRARIAN STRATEGIES TO SELECT SMALL-CAP STOCKS
Widely accepted thinking in the capital markets is the Efficient
Market Hypothesis, which holds that the market prices of public
companies are reflective of all information and are therefore
efficient representations of value Security prices revert back
to the mean as soon as public information becomes available
We certainly do not disagree with the theory in principal Yet
we know that while the market may be perfect, communications and
financial processes are not Relevant financial information
appears slow to diffuse into the marketplace for those companies
with no research coverage, little sponsorship by investment
bankers, or limited ownership by professional investors Since
these are often the circumstances for smaller companies, we
believe the road to price efficiency is somewhat circuitous in
the small-cap sector Indeed, recent studies have shown that
share prices will reflect new information more rapidly as the
number of informed investors increases (3) These studies show
there is a delayed reaction to both common and firm-specific
information among small firms, whereas large firms evidence more
timely reaction Analyst coverage in particular appears
important in adjusting stock prices to new information (4)
Since complete information diffusion is reached at a much slower
pace for the smaller company, we believe the contrarian investor
has time in the small-cap sector to ply his “stubborn,
illogical” style Indeed, empirical evidence has shown that
contrarian portfolio returns are stronger for firms which have a
lower rate of information diffusion One recent study using NYSE
and AMEX listed securities found that the average return
difference between contrarian portfolios in the smallest and the
largest capitalization quintile stocks was 046% per month (5)
Out of Favor Stocks
The contrarian is interested in stocks that the consensus does
not wish to own The stocks may appear relatively inexpensive
based on a discount to its peer group or the market average
Harry Domash’s stock selection service, WinningInvestingcom,
uses the number of analysts’ buy/sell ratings as an indicator of
whether a stock is in or out of favor as an alternative to the
traditional valuation ratios
Capitalizing on Overreaction
Many investors believe the stock market consistently overreacts
to new information, resulting in dramatic price reversals Some
contrarians believe they can make substantial profits in the
short-term by buying the apparent losers and selling winners
Investors using this approach may find helpful the book Stock
Market Overreaction and Fundamental Valuation by Matthias
Kulpmann The book investigates evidence of reversals in the
cross section of stock returns Kulpmann finds that reversals in
stock returns are paralleled by movements in fundamentals
Avoiding the Crowd
While Meyer Rothschild took advantage of the mistakes or
misfortunes of the crowd, modern day contrarians find reward in
simply avoiding the crowd John Summa has written a moderately
entertaining how-to book for such contrarians called Trading
Against the Crowd – Profiting from Fear Greed in Stock,
Futures, and Options Markets Summa puts crowd psychology to use
in spelling out a variety of practical trading strategies such
as Squeeze Play I and II, Tsunami Sentiment Wave, and the Fourth
Estate (The names are the entertaining part)
The Art of Contrary Thinking by Humphrey Neill is another
instructive volume on investor sentiment Neill described “the
crowd” as most enthusiastic and optimistic when it should be
cautious and prudent and fearful when it should be bold He uses
the famous Tulipmania case in late 16th Century Holland as an
example of what happens when everyone thinks alike, ie behaves
according to the crowd Neill advocates that the successful
investor capitalizes on knowledge of crowd behavior
Deep Value
Perhaps a company looks expensive to the rest of the market
based on earnings or return on capital Yet a contrarian finds
the company inexpensive on an absolute basis, trading at a
discount to private market value The deep-value contrarian
looks beyond the obvious to the root cause of earnings weakness
to determine if it is temporary condition and likely to reverse
CONCLUSION
The contrarian investment style is heavily dependent upon
intensive research that goes beyond the summary data provided by
financial services or developed internally by summarizing
company reported financial information Investigating a possible
investment involves communicating directly with company
management, suppliers and customers to determine the company’s
competitive position Relative to other investment strategies,
it may be time consuming to initiate a position Yet where
pricing inefficiencies correct more slowly, contrarian investors
have the time to complete the investigation that others are
unwilling to undertake We believe this makes the contrarian’s
“stubborn and illogical” approach particularly effective in the
small-cap sector
Debra Fiakas, CFA
wwwcrystalequityresearchcom
NOTES
(1) De Bondt, Werner FM, and Richard Thaler, “Further Evidence
on Investor Over-reaction and Stock Market Seasonality,” Journal
of Finance, 1987 Vol 42, pp 557-581
(2) Lakonishok, Joseph, Andrei Shleifer, and Robert Vishny,
“Contrarian Investment, Extrapolation and Risk,” Journal of
Finance, 1994 Vol 56, pp 699-720
MacKinlay, A Craig, “Multifactor Models do not Explain
Deviations from the CAPM,” Journal of Financial Economics, 1995
Vol 38, pp 3-28
Daniel, Kent D, “Evidence on the Characteristics of
Cross-Sectional Variation in Stock Returns,” Journal of Finance,
1997 Vol 52, pp 1-33
(3) Holden, Craig W, and Avandihar Subrahmanyam, “News Events,
Information Acquisition, and Serial Correlation,” Journal of
Business, 2002 Vol 75, pp 247-270
Foster, FD and S Viswananthan, “The Effect of Public
Information and Competition on Trading Volume and Price
Volatility,” Review of Financial Studies, 1993 Vol 6, pp
23-56
(4) Brennan, Michael J, Narasimhan Jegadeesh, and Bhaskaran
Swaminanthan, “Investment Analysis and the Adjustment of Stock
Prices to Common Information,” Review of Financial Studies,
1993 Vol 6, pp 799-824
(5) Yalcin, Atakan “Gradual Information Diffusion and
Contrarian Strategies,” Koc University, College of
Administrative Sciences and Economics February 2003

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