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What sort of investor are you?
There a few schools of thought when it comes to value investing, but two camps in particular that have been in the spotlight recently are contrarian and value investors.
While contrarian investing and value investing have differences, at times contrarian investors are cut from the same cloth as value investing. To understand their similarities we must first understand their differences.
What is Value Investing?
Value investors try to find stocks trading at prices lower than their intrinsic value. When they do, they pounce on these stocks and hold them for a long time in order to reap the benefits. The idea is that eventually the market will catch on to this mispricing and the stock price will move closer to the intrinsic value, and perhaps even beyond.
Value investors are the bargain basement hunters of the investing world, always searching for hidden deals on the stock market.
Buy Cheap and Hold On
Value investors want to buy companies at prices below what they are worth. This way they give themselves the best chance of making a profit, by protecting their downside. It’s a bit like exchanging a $50 bill for $100; what you’re buying is worth way more than what you paid for it.
Calculating intrinsic worth, what a company is actually worth, is a difficult process and an art unto itself. If you can master it, then you can make a lot of money in the financial markets.
Consider the case of Orexigen Therapeutics, a company that specializes in the treatment of obesity. We can look at their balance sheet and see that their assets minus liabilities (net assets) are around $250 million. Using this as a simplistic representation of the company’s intrinsic value, we can see that on a per-share basis, Orexigen is worth about $16 a share. This compares favorably to the current stock price, which, at the time of writing, is around $3.40 a share.
[Editor’s Note: Take these as examples, not recommendations. Prices and values are accurate as of writing but change over time]
Benjamin Graham, the father of value investing, advocated an approach of investing in troubled companies, businesses that other investors weren’t paying attention to, which were trading at prices around two-thirds of their intrinsic value. Basically Ben Graham wanted to pay 66 cents for a dollar. He’d buy these businesses, hold them for a while and then off-load them once they made a profit. He called this the “cigar butt” approach to investing, because he likened the process to picking up a cigar butt on the street that had one last good puff in it, taking a drag, and then throwing it away.
Warren Buffet, perhaps the most famous value investor and second-richest man in the world, was schooled in Ben Graham’s method but has since evolved his strategy. His approach is to buy incredible businesses, companies with a good “moat”, at a great price. They don’t necessarily have to be trading at a huge discount, but it’s essential that the business has some sort of competitive advantage in their industry that makes it almost impossible for rivals to overcome. Buffet’s investments in Coca-Cola and American Express would fit the bill in this category.
Mohnish Pabrai, a well-known value investor and Buffett copycat, is known for sourcing investment ideas in the lists of companies making 52-week lows. This is a bit like shopping for Oscar-nominated movies in the discount DVD bin.
What is Contrarian Investing?
The contrarian investor is tuned into what the market is doing as a whole and tries to go the opposite way. They may bet against stocks that are way above their market value or way below their market value, and are less concerned with mathematical metrics and more on the whims of the herd. They’re like your annoying younger brother that does the opposite of everything you tell him to do.
Bill Ackman, the manager of hedge fund Pershing Square Capital Management, is one such contrarian. In 2012, Ackman took up a position shorting Herbalife stock. Herbalife was doing well, having partnered with numerous celebrities, generating hype while running up their stock price at the same time. After taking a closer look, Ackman concluded that Herbalife was a pyramid scheme – and that their shares were worth $0.
When a contrarian takes a position in one specific stock like this, it’s easy to confuse them for a value investor – they are in a way, just in reverse. After all, Ackman had to do his homework to figure out that Herbalife was NOT worth what everyone thought it was.
Paul Tudor Jones is an example of the archetypal contrarian investor. Not a lot of people can say that they tripled their money on Black Monday in 1987 but Jones did it.
On Monday, October 19th 1987, starting in Hong Kong, the stock markets crashed, causing tons of investors to lose all their money. Jones was ready, having shorted the market in preparation. By the time all was said and done, the Dow Jones dropped 22% and Paul Tudor Jones made $100 million.
Michael Burry is another example, being one of the first people to understand that the housing market in the U.S. was out of control prior to the 2008 recession. Burry, the manager of Scion Capital, delved deep into the sub-prime housing market and saw that too much money was being loaned out to borrowers, people who couldn’t reasonably pay it back in the event the economic conditions softened.
Burry saw through all of this and shorted the riskiest part of the subprime mortgage market. The position initially went against him, Scion Capital ended that first year down 17%, but Michael Burry persevered.
Good thing he did because he made $800 million on that gambit.
Clearly there are similarities between contrarians and value investors. The thing that connects the two types of investors is an appreciation for careful analysis and an understanding of the inherent worth of businesses and how markets operate as a whole.
The difference between contrarian investing and value investing is in the scale and execution – contrarians may make use of more exotic financial instruments like credit default swaps to play an overarching trend while value investors tend to invest in single securities.
Either way, whether you’re a contrarian investing aficionado or value investor, there’s money to be made in the markets.
Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.