The stock market is driven by investor sentiment with share prices often trading nowhere near their true fundamental value. One way to take advantage of this is to adopt a contrarian strategy and look for out-of-favour companies with the potential to turn things around.
Those who rely on this approach use various techniques to identify stocks where they have a high degree of conviction that the market has got it badly wrong. They then open a position and wait for the shares to be re-rated.
This sort of strategy requires a lot of courage because it means going against the herd and having enough faith in your stock picking skills to maintain the investment until the market proves you right.
The contrarian approach is most closely associated with value investors who put together a concentrated portfolio of stocks that are trading at a significant discount to their intrinsic net worth.
Its efficacy is supported by highly regarded academic research including the seminal paper, ‘Does the Stock Market Overreact?’ This was written in 1985 by Werner F M De Bondt and Richard Thaler, and clearly shows that portfolios of underperforming shares often go on to significantly outperform the markets.
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