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How to Become an Intelligent Contrarian Investor

Many investors refer to themselves as “contrarian,” and I’m one of them. But what does that really mean?

After all, anyone can label himself as he sees fit, but labels don’t necessarily convey what he is. I’ve frequently seen investors label themselves “contrarian,” yet by my understanding and use of the word, they’re as orthodox in their thinking as most.

In my lexicon, a contrarian investor must be in the minority. He must act and think differently than the majority. More important, he must act and think differently with intelligence.

In the investing world, the intelligent contrarian looks beyond the obvious, because the obvious conveys no useful insight.

For example, every investor interested in Apple Inc. (NASDAQ: AAPL), and there are many, knows it sits on $147 billion of cash and cash equivalents. Nothing is gained by investing in Apple on that thesis alone; it’s simple, it’s obvious. Yet many investors were purchasing Apple shares on that universally dispersed fact when its shares were trading north of $700.

The great value and contrarian investor Ben Graham pointed out the folly of investing in the obvious 70 years ago. “You are not going to get good results to security analysis by doing the simple thing of picking out the companies that apparently have good prospects,” said Graham.

This makes senses, because good prospects are always reflected in the prevailing market price.  Google’s (NASDAQ: GOOG) prospects are good, which is why its share price has moved to $1,000 from $300 over the past five years, and why it trades at a 36 multiple to earnings.

I suspect many investors have bought, and continue to buy, Google on its good prospects. I’m not one of them.

As a contrarian investor, I know that Google’s good prospects, as currently understood, won’t last indefinitely. In fact, it’s an impossibility.

A dominating business with superior margins and exceptional earnings draws competition. This is an economic fact. Over the long term, every company earns zero economic profits, which means it earns the implied risk-adjusted cost of capital for the industry.  If an industry has an average 10% implied cost of capital, companies earning above that have positive economic profits, which competition will eventually erode.

Positive economic profits correlate with popularity. Most investors are willing to invest in the high-margin, high-growth business. They extrapolate the good time indefinitely, even if the good times are finite.

This notion of zero economic profits relates to return to the mean: the tendency for indices and businesses to return to the central historical valuation. The intelligent contrarian tends to avoid the high-margin, high-growth business because its margins and growth will diminish, which will lead to lower share price.

On the other side, the intelligent contrarian investor will seek unpopular companies or industries that sport margin and growth rates below the historical averages. He’ll also seek investments whose uncertainty and poor immediate prospects investors have extrapolated unreasonably far into the future. This leads to a depressed share price… and an opportunity. It was no coincidence that Warren Buffett loaded up on Coca-Cola (NYSE: KO) in the mid-1980s when most investors believed management destroyed the franchise with the introduction of New Coke.

In High Yield Wealth, many of our better-performing recommendations have been contrarian investments. These companies either had depressed earnings or were out of favor on unreasonable fears.

Indeed, the best-performing open position in the portfolio was a contrarian investment that has returned over 95% in the past two years.

Frustratingly for us, these contrarian investments with the best long-term outlooks are the hardest to sell. I understand; it takes courage to do what most people aren’t doing. But the potential rewards for doing so are well worth enduring spats of isolation and even disdain from the investing majority.