Contrarian Approach

Being somewhat of a rebel most of my life I've always questioned the way things were done and usually ended up doing things my way. With investing it's no different. That's why parts of my investment philosophy and trading strategy seem to disagree with conventional wisdom.

For example, I don't believe in the Efficient Market Hypothesis, which says that everything that is known about a company is already reflected in the stock price. Instead, I believe that the market is a reflection of the irrational actions of its participants.

The tech boom of the late 90's is a prime example. Everything that was known about most Internet companies was that they were losing money and some were deep in debt. Yet, investors kept buying their stock and inflating the share price. Does this sound like an efficient market or irrational exuberance?

Most investors buy stock in a bull market when prices are rising and sell stocks in a bear market when prices are falling. Does this sound like a rational act? Haven't we always been told to buy low and sell high? But many try to buy high and sell higher, and usually end up selling lower. If most investors use this strategy and most investors lose money, doesn't it make sense to do just the opposite?

When it comes to investing, people do the exact opposite of what they would normally do. When making a major purchase of some personal item would you buy when prices were rising or would you wait for a sale? Most people would wait for the sale.

For example, say you wanted to buy a new computer and found two that had all the features you wanted. They both had a retail value of $1,500, but one was on sale for $1,000. Which one would you buy? Most would buy the one on sale.

Now say you wanted to buy a stock and found two that met your criteria. They both had a fair value of $50. One was selling for $75 and making new 52 week highs. The other was selling for $25 and near its 52 week low. Which one would you buy? Most would buy the first stock, which is the exact opposite of what they would have done when deciding which computer to buy.

When a department store cuts prices and announces a major sale people rush to the store to buy stuff, sometimes even if they don't really need it. However, during a bear market where stock prices are cut, people sell their stocks, rather than buy more on sale. During a bull market where stock prices are rising, people rush in to buy stocks at higher and higher prices. This makes absolutely no sense to me.

I look at declining stock prices as a buying opportunity and at rising stock prices as a selling opportunity. Buy low, sell high. I try to buy undervalued stocks in good solid companies with sound fundamentals. That's why I'm willing to buy more stock (i.e. dollar cost averaging) when one of my positions declines in price. I've already determined that the company is a good long term holding and now I can buy more at a discount and lower my cost basis.

This is one of the principals of value investing. Buying undervalued stocks with a margin of safety (i.e. discount to fair value). However, with value investing, sometimes you need to wait for the stock price to decline in order to reach your margin of safety price, and this can take a long time. I create my own margin of safety price by selling covered calls. The premium from the call reduces the cost basis of the stock.

For example, say I wanted to buy a stock for $26.40 but it was currently selling for $30. I could either wait for the stock price to decline 12% or I could buy the stock at $30 and sell a call option for 12% premium, which would result in a net cost basis of $26.40. As long as the call option met my goal of 24% annualized return if called, I'd buy the stock and sell the option rather than wait for the stock price to decline.

My contrarian approach to investing and covered calls is probably different than most investors. I choose to go against the crowd, since I believe that the crowd is usually wrong and irrational. Not everyone will agree with me, but then I'm not looking for agreement. In fact, I'd rather everyone disagree and continue buying high and selling low, so I can do the exact opposite and come out ahead.