How to Beat the Stock Market
with Contrarian Investing
Every stock investor's dream is to buy low and sell high. Yet few investors actually do that. That's why most people lose money in the stock market and many do not make as much as they could.
What if you had a set of tools that told you how to buy stocks when they're cheap . . . and sell stocks when they're expensive?
Sound like a dream? It's not -- it's known as contrarian investing.
The only problem is . . . most people cannot be contrarian investors even when they're handed a blueprint.
Because stocks are cheap only when most investors do not want to buy them. Because stocks are expensive only when most investors want to buy them. And most investors don't want to buy or sell against the crowd. It's hard to zig when everyone else is zagging.
And do understand that contrarian investing works only at the extremes of investor fear and greed. Nobody can predict the market's everyday ups and downs. However, when every investor is optimistic and buying stocks, there's nobody left to sell and therefore keep the prices rising. That's the peak of a bull market.
When fear is running rampant and every investor is selling stocks, there's nobody left to buy and therefore keep the prices falling. That's the bottom of a bear market.
Also, you must understand that contrarian investing is a long term strategy. Both bull and bear markets take time to develop and run. It can take from 1 to 5 years to fully profit from this strategy.
Benjamin Graham asserted that it takes from 18 to 36 months for the market to correct an overreaction on a stock. A study by Werner De Bondt and Richard Thaler showed that "loser" stocks outperformed "winner" stocks by 25% over a three year period.
If you have the patience and guts to sell when everybody else is buying and to buy when everybody else is selling, you can beat the market long term.
In 1986, an assistant professor of business at the University of Kansas, John S. Howe published his findings of the effect of good and bad news on future stock prices.
"Good news" stocks that had increased in price by at least 50% actually underperformed the market for the next year - by 30%. "Bad news" stocks that had decreased in price by at least 50% actually outperformed the market for the next year.
If you think you have the emotional control it takes to beat the stock market, here's a short guide to buying stocks the contrarian investing way.
First rule of thumb: Consider buying only stocks whose price has declined at least 50% in the past 12 months. Howe's study shows that these stocks do tend to rise in price.
If a company goes from $50 to $40, that is not a contrarian play. If a company goes from $50 to $25, it may be a good contrarian play. That's the first screen. Do not consider buying any stock unless its current price is at least 50% less than its prior 12 month peak.
Then you must look for other indicators:
1. Insider trading or significant purchases by well-known investors such as Warren Buffett.
At least two academic studies have concluded that significant buying by company insiders is a market-beating bullish signal.
Company officers must report when they buy and sell shares of the company they work for. This is public information. You can find information on insider trading through special publications, The Wall Street Journal, and various websites.
2. A low P/E (price earning ratio). This is a well-known indicator and found in most stock price listings. It's the stock's earnings per share divided by the stock's price. The lower the P/E Ratio, the more company earnings each one of your investment dollars is buying. Below 12 to 15 is generally low.
3. A low price to book value ratio. Book value is an accounting figure that represents the current state of the original cost of the company's assets. A ratio under 1 is desirable.
4. A low price to sales ratio. A company is only as good as its sales. A ratio of price to sales per share is desirable. This ratio must be calculated from a company's annual report. A ratio under 1 is desirable.
Academic studies and findings by James O'Shaughnessy in his book WHAT WORKS ON WALL STREET validate that buying stocks based on low P/E, low price to book value ratio or low price to sales ratio beats the return of the overall market in the near to mid term (up to five years).
Buy stocks that:
1. Are down in price by 50% from their 12-month peak.
2. If stock shows significant insider buying with no selling, it's a buy.
If no significant insider trading, buy if the P/E ratio is below 12 and either the price to book value is below 1. Or if the price to sales ratio is below 1. These ratios will be low only for stocks that are out of favor with investors. Those are the companies that can make you wealthy.
Diversify. Some stocks go down and never go back up. So don't put all your investing money into any one company.
Keep your emotions under control. Look for companies that are beaten down from their highs and who have significant insider trading or low price ratios. Be patient. Be prepared to wait from one to five years.
If contrarian investing were easy, everybody would do it -- and it wouldn't be "contrary" anymore.
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