New York - Yes. Contrarian investing is driven by the belief that stocks and markets are driven by intangible emotions which cause stocks to differ from their intrinsic value. It is a disciplined investment approach that helps investors avoid emotional traps. This strategy seeks to profit by purchasing stocks that are out-of-favor or low relative values as compared to other stocks, and it avoids high-flying stocks that have been pushed up by market euphoria.
Two standard contrarian valuation models are as follows:
- Dividend Yield Model - The dividend yield of a stock is found by dividing the annual dividend by the current price. Stocks with high dividend yields, when compared against competitors within a particular industry or the market as a whole, generally indicate an out-of-favor stock. The high dividend yield provides price support for the stock until it gains favor again.
When using the dividend yield model investors need to ensure that the dividend payout ratio (the ratio of dividends per share divided by earnings per share) is consistent and stable when compared to industry competitors. Dividend payouts between 0 to 60% can be signs of future stability in the stock while payout ratios over 60% can be signs of potential future dividend cuts. Any dividend payout ratios over 80% should be avoided due to unnecessary risk unless the ratio is high due to a one-time write-off of expenses.
- Price Earnings Model - Price earnings (PE) are calculated by dividing the market price per share by the current or projected annual earnings per share. It measures the market's expectations regarding earnings growth potential and risk. Stocks with low PE ratios, when compared against competitors within a particular industry or the market has a whole, may indicates an out of favor stock. These stocks may be negatively impacted by poor recent earnings, product failures or industry trouble.
Low PE ratio stocks typically have more positive earnings surprises than high price-earnings ratio stocks. In addition, when a low PE ratio stock has a negative earnings surprise, it will not be as severe as that for high price-earnings ratio stocks.
Regardless of which models you choose; you need to ensure that you believe that these companies will continue to grow and prosper and that any problems or issues being faced are temporary.
Although any stock, including small-cap stocks, can be purchased using a contrarian method, we prefer large and medium sized companies because we perceive there is less overall risk. Large companies generally have managerial and financial resources to combat an industry or particular problem as compared to smaller companies.
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