Contrarian Investing: Skipping the Academics
By: Daniel Eskin Thu, Oct 1, 2009
An “expert” is somebody who knows more and more about less and less. Keep that in mind while reading this post.
A contrarian is the odd one out.
As a follow up to my previous post on contrarian investing, I’d like to explain to you why a majority of investors, both in industry and personal, undergo flawed investment strategies. These findings originated from David Dreman and his market research team, although I’m sure it has been noted by many others.
1. The story starts with human limitations. Have you ever heared that the reason phone numbers are only 7 digits long (in Canada anyway) is because that is the maximum our minds can retain? Similarly, the average person can only entertain 2-3 ideas at a time. The idea I am leading towards is human beings have a massive lack of ability in analyzing a lot of data configuraly (means analyzing data not only on their own accord, but also on how data affect each other).
2. The other side of the story has to do with a general human trait to be overoptimistic. Over 60% of drivers say they are better than average – yup! 80% of entrepreneurs believe their chances of success are over 70%, whereas survival rate in reality is about 33% after 5 years – yup! Investors are also human – yup!
So, any human being who is exposed to masses of equity data, economic data, interest rates, competitive factors, future projections and plans etc., has 0% chance of being completely right, and most often very far from estimates to even be a successful investor. What’s more is that “experts” in the industry tend to be even more optimistic and confident due to their status, but in reality analyze SOOO much information and charts and reports and tables that they are incredibly vulnerable to mistakes.
In fact, here’s a pretty self-evident survey showing the number of forecasts made by “experts” and the amount of times they performed lower in the market (it’s a little outdated, but whatever, the data still speaks for itself; modern financial models haven’t changed dramatically in the last decade). As I said, these “experts” who have tons of experience just feel like they built the ability to analyze more and more data as it comes at them through their professional demands are in fact being highly over-optimistic of their skills. Point proven:
What I took from all this research performed by Dreman is that correlations are so easy to misinterpret so decisions based on factors like beta, interest rates, future projections, economic factors, oil prices etc. should be avoided.
As humans and investors, we have to appreciate our limitations of working with mass information. Few of us can get it right (i.e. Buffett). In-depth information does NOT translate into in-depth profits in 99% of all cases; quite the contrary. Facts that are mere coincidences can seem like obvious correlations. There are NO highly predictable industries in which you can count on analyst estimates, because being exposed to so much data (and being highly overconfident), they are more likely to be wrong than even individual investors.
Overall: skip the academics. Current security analysis requires precision in estimates of earnings, cashflow, dividends etc. that is impossible to provide. Investment strategies that circumvent stumbling into these masses of data are out there. More coming in the next article!
Last 3 posts by Daniel Eskin
- Short-term Versus Long-term Investments - March 16th, 2010
- Expert Interview - Puru Saxena - March 9th, 2010
- Memory of a Crisis - March 8th, 2010
Tags: Buffett, contrarian, contrarian investing, Dreman, equities, investing
I agree with this article. Although there are those that make money off of short-term investments, they usually end up losing just as much, if not more. Sound business practices and a good idea are what generates a return on investment, not beta and correlations.
Totally agree with your point of view Dan…very interesting table that you included in the article.
I’ve always been skeptical of analyst reports because of this simple observation: If you chart the price targets placed on stocks by analysts on top of the actual stock price…you’ll see that the price targets follow the stock price very very closely, snaking up and down along with the price. That clearly should not bee the case if analysts are attempting to establish the LONG-TERM value of a company, which really shouldn’t fluctuate with daily price movements!
An interesting viewpoint. I’m newish to investing and I probably have not paid enough attention to contrarian methods.
Be sure to check out the follow-up article to this then Senan since it will go a little more in-depth into types of strategies contrarian investors use =)
Great article!
I have the same view as you in terms of analyst reports Shishir. I’ve seen analyst upgrade rating on a company yet they decrease their target…I tend to pay little attention to analyst reports unless the analyst has made consistent good calls and I’m glad to say that I’ve had no complaints as of yet.
All the best to you guys and keep it up!
Thanks for the comment Steward. Kind of makes you wonder why there are so many analyst jobs… maybe their superiors should read this =)
Great post Daniel,
Agree wholeheartedly, but the question remains – how then do outsiders make correct investment decisions?
Aside from “Buffeting” through meeting management and having first hand experience with operations at firms (opportunities the average investor does not have), what else is there besides financial statement data to make decisions on?
Basing decisions on economic theory has it’s limitations, because even if you can correctly identify the growth sectors, an analysis of equity price is still necessary to determine if said growth is already priced in, and any price analysis has to incorporate some sort of financial model of earnings and CF.
Great blog overall, looking fwd to the follow up to this one.
Thanks for the reply Brandon. I really believe outsiders would benefit by using contrarian methods described in a few books I read recently. They don’t have to abide to “popular” or large-cap stock requirements, so makes it easier to select some unknown and likely more potential-filled stocks.
Apart from financial data, there is a ton of qualitative information available. Company website is a great place to start – see how they are interacting with customers, whether their product really strikes you as something you would purchase if you were in their target market (or if you already have), see if they are using new-age marketing strategies etc. Other things like management qualifications and insider buying is important. But that’s a bit of a different topic
Thanks for the compliment Brandon. Send me an email at daniel.eskin@utoronto.ca so I can get your e-mail address – wanted to share a cool stock idea I read about today!