The Contrarian Story

q      It is always darkest before dawn. At least, that is the belief that lies at the heart of every contrarian investing strategy. The best time to buy a stock is not when good news comes out about it but after a spate of bad news has pushed the price down, making it a bargain. The story rests on the assumption that the average investor tend to over react to news good as well as bad and that investors who are a little less driven by emotion (presumably you and I as contrarians) can take advantage of this irrationality. The story sells well, at least in the abstract, to those who have the least faith in human rationality. The assumption that investors over react ties in neatly with the widely held view that crowds are driven by emotion and can be swayed by peer pressure to irrational acts. This view is reinforced in financial markets by the bubbles in prices from the South Sea Bubble in the 1600s to dot com companies in the 1990s that show up at regular intervals.

q      Lower priced stocks are cheaper: There is another and less rational factor behind the contrarian story. Stocks that have gone down a lot often trade at low prices and there is a feeling among some investors that a lower priced stock is cheaper than a higher priced stock. Thus, a stock that has dropped from $ 30 to $ 3 looks cheaper on an absolute basis to many investors. The danger, of course, is that the value of this stock (which is what you should be comparing the price to) might have dropped from $35 to $1 during the same period.