Contrarian Investors Target Promising Out-of-Favor Stocks
Andrew Leckey

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Running with the herd is the most popular way to invest because everyone will commend you for heading in the right direction.

Taking a contrarian view, on the other hand, opens you to ridicule from your peers. You may seem out of step, as if you missed getting the proper message or aren't smart enough to grasp the obvious.

"Contrarian investing is basically going against the grain and doing the opposite of what the majority is doing," explained Paul Merriman, editor of www.fundadvice.com in Seattle. "Most people are emotional market timers, and this is indicated by their huge commitment right now to bonds."

Stock investing in general has probably been the most significant contrarian investment of the past year because investors have been so wary, Merriman believes. A lot of stock gains were missed as a result.

"The approach to contrarian investing is to look for companies in situations that are misunderstood and out of favor," said David Decker, manager of Janus Contrarian Fund, which used the market downturn of 2008 and early 2009 to snap up stocks such as Apple Inc. (APPL). "Just keep in mind that the market is right quite often, so being a 'knee-jerk' contrarian is dangerous because a good return shouldn't be dependent on the future unfolding in the perfect fashion you envision."

Decker's Janus Contrarian Fund (JSVAX) is up 64 percent over the past 12 months with a three-year annualized decline of 4 percent. This "no-load" (no sales charge) fund requires a $2,500 initial investment and has an annual expense ratio of 1 percent.

His largest stock holding, the Florida-based St. Joe Corp. (JOE) real estate development firm, is an out-of-favor investment he researched well. The stock had fallen 33 percent in 2007 and 32 percent in 2008, but gained 19 percent last year and is up 15 percent in 2010.

While the company still isn't making money, usually a bad sign, it owns land worth considerably more than its current stock price, he believes. With the Northwest Florida Beaches International Airport opening near Panama City, the economic development in the region is going to expand. The fact that St. Joe owns the land around the airport has yet to be reflected in its stock price, he noted.

Investors interested in a contrarian approach either invest in a fund that is truly contrarian, find an advisor with that mindset or begin to research good companies with temporary woes on their own.

"A lot of statistical work has shown that if you bought out-of-favor stocks you would have done significantly better than the market in almost every decade since they started measuring it," said David Dreman, chairman and chief investment officer for Dreman Value Management LLC in Jersey City, N.J. "Contrarian investing is a form of value investing with a powerful research background that has worked well for 40 years."

His Dreman Contrarian Small Cap Value Fund "R" (DRSVX) is up 65 percent over the past 12 months and has a five-year annualized return of 5 percent. This no-load fund requires a $2,500 initial investment and annual expense ratio of 1.38 percent.

An indication that Dreman is a true believer in contrarian philosophy: He invests a considerable portion of his own net worth in the fund.

He prefers companies with strong cash flow, accelerating returns on invested capital and smart management--putting money in them when their stock price is temporarily cheap. He invests across all types of industries as well as overseas markets.

"There are two possible problems with contrarian investing," cautioned Merriman. "First, value can underperform growth for a decade and you give up on it or, second, in a depression the contrarian choices are likely the first ones to go under because they already have their own problems."

Contrarian is nonetheless a philosophy espoused by some of the best investors.

Bill Gates and Warren Buffett bought into Republic Services Inc. (RSG), the second-largest waste collection firm, last November. They didn't expect high growth, but rather consistent growth and an eventual return to favor, Merriman said. The firm's ownership of landfills is impressive and new competitors in the field are limited.

"If the fundamentals of a company are pretty good but for some reason or another it is out of favor, it should do well over the long run," said Dreman.

At the beginning of 2009 Dreman was buying unwanted financial stocks such as JPMorgan Chase & Co. (JPM), PNC Financial Services (PNC) and Wells Fargo (WFC), as well as out-of-favor oil service companies such as Devon Energy Corp. (DVN), Apache Corp. (APA) and Chesapeake Energy Corp. (CHK). The future of both groups was too bright to overlook, he believed.

"We look for an asymmetrically positive risk/reward in which the downside is relatively limited and the upside disproportionately large, then build a portfolio around those companies," said Decker. "As long as the company isn't about to go bankrupt, the question is how much the market has priced in bad news and whether the price is attractive enough."

Major holdings in Janus Contrarian besides St. Joe include Kinder Morgan Management LLC (KMR), British American Tobacco Plc. (BAT), the DIRECTV Group Inc. (DTV), CB Richard Ellis Group Inc. (CBG) and Japan Tobacco Inc. (JT).