Contrarian Investment Strategies: The New Generation- Book Notes

Contrarian investment strategies work. But we do not follow them through for the long term because very often they underperform the market for a significant period of time.

1. Do not use market-timing or technical anlaysis. These techniques can only cost you money.

2. Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate to in-depth profits.

3. Don’t make an investment decision based on correlations. All correlations in the market, whether real or illusory, will soon shift and disappear.

4. Tread carefully with current investment methods. Our limitations in processing complex information correctly prevents their successful use by most of us.

5. There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble.

6. Analysts’ forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimates.

7. Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

8. It is impossible, in a dynamic economy with constantly changing political, economic, industrial and competitive conditions, to use the past to estimate the future.

9. Be realistic about the downside of an investment, recognising our human tendency to be overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.

10. Take advantage of the high rate of analyst forecast error by simply investing in out-of-favour stocks.

11. Positive and negative surprises affect the best and worst stocks in a diametrically opposite manner.

12. Surprises, as a group, improve the performance of out-of-favour stocks, while impairing the performance of favourites. Positive surprises result in major appreciation for out-of-favour stocks, while having a minimal impact on favourites. Negative surprises result in major drops in the price of the favourites, while virtually having no impact on out-of-favour stocks. The effect of an earnings surprise continues for an extended period of time.

13. Favoured stocks underperform the market, while out-of-favour companies outperform the market, but the reappraisl often happens slowly, even glacially.

14. Buy solid companies currently out of market favour, as measured by their low price-to-earnings, price-to-cashflow or price-to-book value ratios, or by their high yields.

15. Don’t speculate on highly priced concept stocks to make above average returns. The blue-chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman or woman.

16. Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price-to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.

17. Buy only contrarian stocks because of their superior performance statistics.

18. Invest equally in 20 to 30 stocks, diversifies among 15 or more industries( if your assets are of sufficient size)

19. Buy medium or large sized stocks listed on the New York Stock Exchange, or only larger companies on Nasdaq or the American Stock Exchange.

Ancillary indicators:

  • A strong financial position
  • As many favourable operating and financial ratios as possible
  • A higher rate of earnings growth than the S&P 500 in the immediate past, and the likelihood that it will not plummet in the near future.
  • Earnings estimates should always lean to the conservative side.
  • An above-average dividend yield, which the company can sustain and increase

20. Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

A rule of thumb might be to use a 20% discount or more from the S&P 500’s P/E, P/B. P/CF ratios or an yield of 1% above the S&P 500.

Other methods are buying value mutual funds or index funds.

21. Sell a stock when its P/E ratio( or other contrarian indicator) approaches that of the overall market, regardless of how favourable prospects may appear. Replace it with another contrarian stock.

If a stock does not work out sell it within 2.5- 3 years; probably 3.5 years for a cyclical. Maximum is 6 years( as used by John Templeton)

Sell a stock immediately if the long term fundamentals deterirate significantly.

Do not sell a stock that attains a high P/E solely because of a decline in earnings, because of a large one-time charge or temporary business conditions.

22. Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in a marked different outcome.

23. Don’t be influenced by the short-term record of a money manager, broker, analyst or advisor, no matter how impressive; don’t accept cursory economic or investment news without significant substantiation.

24. Don’t rely solely on the “case rate”. Take into account the “base rate”- the prior probabilities of profit or loss.

25. Don’t be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms( the “case rate”). Long term returns of stocks(the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

26. Don’t expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.

27. The push towards an average rate of return is a fundamental principle of competetive markets. Regression to the mean is the norm.

28. It is far safer to project a continuation of the psychological reactions of the investors than it is to project the visibilities of the companies themselves.

29. Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, do not sell.

30. In a crisis, carefully analyze the reasons put forward to support lower stock prices- more often than not they will disintegrate under scrutiny.

31. Diversify extensively. No matter how cheap a group of  stocks looks, you never know for sure that you are’nt getting a clinker. Use the value lifelines- a lower P/E, a lower P/B and a higher dividend yield. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

31. Over the very long run, stocks and real estate perform better than bonds and cash.

32. Volatilty is not risk. Avoid investment advice based on volatility. Risk is permanent loss of capital. Irrespective of size low P/E does better( from $100 million- >5 billion).

33. Small- cap investing: Buy companies that are strong financially( normally no more than 60% debt in the capital structure for a manufacturing firm)

34. Small- cap investing: Buy companies with increasing and well protected dividends that also provide an above- market yield.

35. Small-cap investing: Pick companies with above average growth rates.

36. Small- cap investing: Diversify widely, particularly in small companies, because thes issues have far less liquidity. A good portfolio should contain twice as many stocks as an equivalent large-cap one.

37. Small-cap investing: Be patient. Nothing works every year, but when small caps click, returns are often tremendous.

38. Small company trading: Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.

39. When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large your total cost will be.

40. Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.

41.  A given in markets is that perceptions change rapidly.

Psychological guidelines which are additional guidelines in the new edition: Contrarian Investment Strategies: The Psychological Edge

Do not abandon the prices projected by careful security analysis, even if they are temporarily far removed from current market prices. Over time the market prices will regress to levels similar to those originally projected.

Do not rely solely on the “case rate”. Take into account the “base rate”, the prior probabilities of profit or loss. Long term returns of stocks( the “base rate”) are far more likely to be reestablished.

Don’t be seduced by recent rates for return( the “case rate”) for individual stocks or the market when they deviate sharply from past norms. If returns are particularly high or low, they are likely to be abnormal.

Look beyond obvious similarities between a current investment situation and one that appears similar in the past. Consider other important factors that may result in a markedly different outcome.

Don’t be influenced by the short-term record or “great” market calls of a money manager, analyst, market timer or economist, no matter how impressive they are; don’t accept cursory economic or investment news without significant substantiation.

The greater the complexity and uncertainty in the market, the less emphasis you should place on the case rate, no matter how spectacular near-term returns are, and the more on the base rate.

Don’t expect that the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.

Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits.

Don’t make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.

Analysts’ forecasts are usually overly optimistic. Make the appropriate downward adjustment to your earnings estimate.

Tread carefully with current investment methods. Our limitations in processing complex information prevent their successful use by most of us.

The probability of achieving precise earnings estimates over time is miniscule. Do not use them as the major reason to buy or sell a stock.

There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on their estimates will lead you to trouble.

Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

It is impossible, in a  dynamic economy with continually changing political, economic, industrial and competitive conditions, to use the past to estimate the future.

If you are interested in an analyst’s recommendation, get all of his reports for at least the last three to five years and see how they’ve done. If they haven’t done well or he can’t provide them, move on.

The outside view ( rather than the inside view of forecasting) normally provides superior returns over time. To maximize your returns, purchase investments that provide you with this approach.

Be realistic about the downside of an investment; expect the worst case to be much more severe than anticipated.

Earnings surprises help the performance of out-of-favour stocks, while affecting the returns of favourites negatively. The difference in returns is significant. To enhance portfolio performance, you should take advantage of the high rate of analysts’ forecast error by selecting out-of-favour stocks.

Positive and negative surprises affect “best” and “worst” stocks in a diametrically opposite manner.

Surprises, as a group, improve the performance of out-of-favour stocks, while impairing the performance of favourites.

Positive surprises result in major appreciation for out-of-favour stocks, while having minimal impact on favourites.

Negative surprises result in major drops in the price of favourites, while having virtually no impact on out-of favour stocks.

The effect of an earnings surprise continues for an extended period of time.

Favoured stocks underperform the market, while out-of-favour companies outperform the market, but the reappraisal often happens slowly, even glacially.

Low P/E, low P/cash-flow, low P/B, high-yield and low P/industry are the five strategies.Buy solid companies currently out of market favour, as measured by the above strategies.These strategies will outperform usually only over longer periods of time: 5-10 years or more.You can buy stocks that fit into low P/E category and hold them for 2-8 years time and the results will be similar.

Don’t speculate on highly priced concept stocks to make above-average returns. The blue-chip stocks that widows and orphans traditionally choose normally outperform the riskier stocks recommended for more aggressive businessmen or women.

Avoid unnecessary trading. The costs can lower your returns over time. Buy and hold strategies provide well-above-market returns for years and are an excellent means of lowering turnover and thereby significantly reducing taxes and excess transaction costs.

Buy only contrarian stocks because of their superior performance characteristics. Invest equally in 30-40 stocks, diversified among 15 or more industries( if your assets are of sufficient size)

Buy medium or large sized stocks listed on NYSE or only larger companies on NASDAQ or AMEX.

Buy stocks in the bottom 20% quintile. Look for a strong financial position, as many favourable operating and financial ratios as possible, higher rate of earnings growth than the S&P 500 in the immediate past and the likelihood it will not plummet in the near future. Estimate earnings ultraconservatively and also look for an above average dividend yield.

Never buy a company that is losing money.Never believe senior officials up to the cabinet level when they say all is well in trying times for a company or an industry. In most cases it is time to let the stock or industry go.

The investor psychology we have examined is both your biggest ally and your worst enemy. In order to win, you have to stay with the game, but for many people that is difficult to impossible.

Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group is and rebalance annually or in 2 years.

Liquidity decreases as stocks fall in price and increases as they gain in price.

The prudent investor should stay away from leverage or margin and hold only a small part of his or her portfolio in illiquid securities.

Because of inflation and taxes, stocks and housing are better than bonds and cash over the long term.

Do not buy puts or calls unless you are highly experienced with them. Consider ETFs and index funds, sector funds, mutual funds that have beaten the market over 10 years and have the same manager.

Use a buy and weed strategy: sell stocks if they move up to or above market ratios or do not perform as well as the market after a certain period of time. Consider buying foreign ETFs and mutual funds.

Sell a stock when its P/E ratio( or other contrarian indicator) approaches that of the overall market, regardless of how favourable its prospects may appear. Replace it with another contrarian stock.

Sell a stock after 2.5-3 years if it does not perform. For a cyclical stock with a drop in earnings, this may be stretched to 3.5 year. John Templeton, a master of value investing sold after 6 years if a stock did not perform.

Sell a stock  if its long-term fundamentals deteriorate significantly.

It is counterproductive for investors with investing time horizons of thirty, twenty, ten, or even five years to focus on short-term fluctuations.

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