How to invest like a 'greedy' Buffett

Sorry to be the one to point this out, but you've got this contrarian thing all wrong.

Going against the grain just for the sake of it does not make you a contrarian. Just because a stock or the overall stock market is up a lot doesn't mean you should just sell or bet on a decline in prices. And vice versa for when a stock or stock market retreats.

It wouldn't be possible to bring up the subject of what it takes to be a contrarian without mentioning the ultimate value investor, Warren Buffett, famous for saying that the time to be greedy is when others are fearful. More recently, Buffett said at the last Berkshire Hathaway shareholder meeting that a value investor who can't take pain isn't a value investor at all. That makes so much sense when you think about it.

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Value investors make for good contrarians.

When Buffett purchased stocks during the Great Recession, he was quite selective—strong balance sheets, experienced management, and a long time horizon. While the jury may still be out for some purchases, it is hard to argue that Buffett's contrarian style hasn't paid off while offering a relatively smooth ride.

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To me the definition of being a contrarian is threefold. First, it means buying a company that other investors have lost patience in, one in which expectations have been wrung out of it. But it also requires identifying a company that will execute a plan to grow the business and at the same time has decent fundamentals—a strong and flexible balance sheet, steady if not slowly rising or falling revenue—so that if the plan takes longer to execute or if it doesn't work, you'll at least potentially have something of value that you could sell at a later date.

"It is the most awful thing to hear a well-intentioned investor say, 'The stock is down; I should buy more' or 'If everyone is selling, then I'll buy.' This is a sign of laziness." -Mitch Goldberg, president, ClientFirst Strategy

The most important question that I ask myself before I add to a position after a major pullback—10 percent or more—is this: If I didn't own the stock already, would I initiate a new position in it?

If the answer is yes, then I give myself the green light to buy on the dip. If I say no, then I would sell it. If I feel I don't have strong enough of a view and if I don't need to make the decision immediately, I'll take some time to reevaluate corporate news, fundamentals, and monitor upcoming news.

The fact is, sometimes stocks drop for the right reason and sometimes for the wrong reason, and the difference is not always clear-cut. But if you are a contrarian, you must be willing to sit on a position that could be dead money for a while and be willing to monitor corporate developments. (I am talking about contrarian in terms of long-term investing, by the way. For a trader, if the answer to the above question was a "no," I'd be a seller right away. Plus, my 20 percent would be more like 2 percent to 5 percent.)

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It is the most awful thing to hear a well-intentioned investor say, "The stock is down; I should buy more" or "If everyone is selling, then I'll buy." This is a sign of laziness. One must explore the reasons for the retreat in the stock. I always have stocks in my book of business that are down from where I bought them. But if they pull back and the reasons for my original purchase are still intact, then and only then do I buy more.

Just to be sure we're on the same wavelength, I am talking strictly about contrarian investing in the context of long-term investing. For disciplined day traders, they'd be long gone well before a stock retreats 10 percent. A contrarian is looking to stick with a stock through cycles that include momentum and stagnation because, with a longer time horizon, your odds are higher that you'll realize the full benefit of your reasons for buying in the first place.

How much time is too much time? When I initiate a contrarian-type investment, I give it two years to start seeing results. Why? Because from my experience, that is how long it takes for management to draw its plans and for employees, customers, vendors, restructuring activities, analyst ratings and shareholder perception to all come on board. If it happens sooner and that has often been the case, great. But if it takes longer, then I have to start questioning whether or not the management plans are still relevant.

The 4 characteristics of a true contrarian

1. They do not give themselves time limits, but they do monitor corporate results. There is a matter of trust in corporate management that it will be able to deliver upon laid-out plans. Sometimes things don't work out.

2. They practice diversification, since, as I said above, sometimes things just don't work out!

3. They look for potential catalysts, such as restructurings, division spinoffs, potential buybacks and industry consolidation. Specifically, Iook for when an industry's growth becomes stagnant but the revenue is stable, which often means that for a company to grow earnings and cut costs, buying out a competitor could potentially be a way to accomplish this.

4. They know (or at least they should) that valuation in and of itself is almost never… NEVER … a stock-moving catalyst. Valuation may move corporate managements toward action or may attract the interest of an activist investor, but without a catalyst to stop the inertia, undervalued and overvalued stocks often become even more so.

Tuning out the noise

The four things I hear the most from investors who think a stock is undervalued and therefore should be bought are:

  1. "It has a low P/E ratio."
  2. "It's at or near an annual low."
  3. "Insiders are buying."
  4. "It has a big dividend."

Oh, man, I have seen so many investors lose money when using these characteristics in choosing a stock!

Not to say that one or more aren't legit reasons to be a part of your thesis, but there are so many bad reasons that could account for these stock characteristics. I usually find that, in fact, the negatives far outweigh the positives. For example, consider the following four counterarguments to the "contrarian" thinking espoused above:

1. A low P/E ratio could mean the same thing: that the stock went down and that future earnings are expected to be lower, which means that over time the low P/E could be a very misleading indicator of value.

2. Likewise, a stock at the low end of its 52-week trading range may often signal that the company is facing severe financial challenges. Did the company indicate that they face a threat to earnings and this is why the stock is at an annual low? Not for me, thank you very much.

3. The ol' "insider buying" thing? Well, not too long ago I saw insider buying in a coal producer. Just take a look at how well the coal stocks have done and you'll see a sector that generally had all of these four characteristics but (get ready for the pun) burned investors anyway!

4. And lastly, sometimes a fat dividend happens just because the stock is down so much that when you divide the dividend into the current stock price, it looks more attractive. But if the stock fell due to a drastic cut in earnings outlook, then you could potentially be faced with a sharp dividend cut.

The best advice I give to both myself and to aspiring contrarians? Start by looking at good, solid companies that you'd feel comfortable holding even when they're down—the ones that have survived and morphed through good times and bad. Just like your mama, and Warren Buffett, told you.