No Extra Credit for Being a Contrarian

April 19, 2012 — Leave a comment

I’ll make no claims that the Shleifer Effect is an original construct. Far from it. The denizens of behavioral finance borrowed its academic tenets from social psychology. For investors removed from the ivory tower, the Shleifer Effect pulls from Benjamin Graham’s bi-polar Mr. Market, Sir John Templeton’s suggestion to buy when there’s blood in the streets, and even from Joel Greenblatt’s magic formula for spotting strong businesses that are out of favor.

The Shleifer Effect is a term I coined to be my own mental heuristic, encapsulating all the concepts above while adding a few minor wrinkles of my own. It’s a few different models condensed into one for the purpose of creating mental shortcuts for my screening and evaluations.

This morning Joe Koster of Value Investing World posted the quote below from Warren Buffett (here). It’s an important addition to the Shleifer Effect as a heuristic. Pessimism creates opportunity, but just because investors are selling out of a company doesn’t mean the company is investment-worthy for you. More often than not a business has a falling price and a low market value for a reason. That means you’ll reject most (indeed, nearly all!) ideas produced by screens searching for businesses with bad earnings reports or other such news.

The business must be fundamentally sound, or at least much better off than the market is giving it credit. We’re looking for companies operating good businesses that happen to be misunderstood or unpopular.

There is no extra credit for being contrarian. You must be right!

“The most common cause of low prices is pessimism – some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What’s required is thinking rather than polling. Unfortunately, Bertrand Russell’s observation about life in general applies with unusual force in the financial world: ‘Most men would rather die than think. Many do.’”

Paul Dryden

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