Does a contrarian investing strategy yield better results? An analysis

Savvy investors buy stocks for the long term with an aim to beat market returns over a period of time. It not only takes skill to identify such counters among the myriad choices available, but also disciplined investing. 

While the strategy of ‘going with the flow’ and buying/selling stocks as most other investors/traders are doing is common, it takes skill to identify stocks and a lot of courage to make an investment decision that is contrary to the popular trend. Swimming against the tide is a risky proposition and may/may not yield the desired result.

A recent study by Motilal Oswal Research reveals that by investing in stocks for which consensus recommendation has changed from ‘net sell’ to ‘net buy’ as soon as they have been upgraded, and then holding them for 12 months, an investor would have earned an average return of 21.1 per cent.

The brokerage looked at instances of change in consensus rating from ‘net sell’ to ‘net buy’ over 2006-2019 across BSE-100 constituents. A change in consensus rating from ‘net sell’ to ‘net buy’ implies a change in consensus rating from less than 3 (<3) to greater than 3 (>3).

"Our analysis suggests that over a longer term, neutral-to-moderately popular stocks deliver a significant outperformance, even bettering the performance of the most popular stocks. In 1QFY20, the most popular stocks performed the best, beating the benchmark, whereas the neutral to moderately popular stocks delivered the third best return," the report says.

So, what are these contra plays?

Essentially, these are stocks that have been ignored, have negative news flow and are battling short-to-medium-term challenges. Typically they have consensus popularity rating of <3. 

"Marginal earnings surprise, an improvement in news flow and beaten down valuations are some of the factors that result in popularity scores moving closer and then upwards of 3 (net buy). These stocks are yet to become over-owned/most popular names on the street," the report says.

Simply put, the investment philosophy suggests that when consensus recognises the changing fortunes of an underlying business and upgrades ratings, it pays to be among the early birds in investing in such a business. 

"Our study shows that returns earned from this strategy are healthy even in absolute terms. However, one needs to be early to catch these returns, certainly before the stock becomes a consensus buy and crosses a popularity score of 3.5," says Gautam Duggad, head of research at Motilal Oswal Financial Services in the co-authored report with Bharat Arora.

Neutral to moderately popular stocks, the Duggad says, are usually neglected by the street and their drivers are evolving. As the drivers evolve, there is a sudden surge in investor interest in such stocks, leading to a spike in returns. Thus, the stocks that were previously neglected by investors deliver significant outperformance.

"On the other hand, the least popular stocks underperform. This is because the least popular stocks have a lot of sell recommendations. Sell recommendations are not popular on the street – only about 16 per cent of recommendations are sell as against 60 per cent buy and 24 per cent hold. So, they have scarcity value and are more likely to be acted on," the report says.