Contrarian Investing: Buy When There's Blood in the Streets

The worse off the market is, the better the opportunities are to profit. That's seemingly the credo for contrarian investing. Nathan Rothschild, a 19th-century British financier and member of the Rothschild banking family, is credited with saying that "the time to buy is when there's blood in the streets."

Whether or not Rothschild actually uttered the famous line, it reveals an important truth about betting against market psychology. When prices fall and markets tremble, a bold contrarian investment could reap high profits.

Most people only want winners in their portfolios, but as Warren Buffett warned: "You pay a very high price in the stock market for a cheery consensus." In other words, if everyone agrees with your investment decision, then it's probably not a good one.

Going Against the Crowd

Contrarians, as the name implies, try to do the opposite of the crowd. They get excited when an otherwise good company has a sharp, undeserved drop in the share price. They swim against the current and assume the market is usually wrong at both its extreme lows and highs. The more prices swing, the more misguided they believe the rest of the market to be.

A contrarian investor believes the people who say the market is going up do so only when they are fully invested and have no further purchasing power. At this point, the market is at a peak and must go down. When people predict a downturn, they have already sold out, at which point the market can only go up. For this reason, a contrarian mindset is great for sussing out whether or not a particular stock has actually bottomed out.

Bad Times Make for Good Buys

Contrarian investors have historically made their best investments during times of market turmoil. During the crash of 1987 (also known as "Black Monday"), the Dow dropped 22% in one day in the U.S.

In the 1973–74 bear market, the market lost 45% in about 22 months. The attacks on Sept. 11, 2001, also resulted in a sizable market drop. The list goes on and on, but those are times when contrarians found their best investments.

The 1973–74 bear market gave Warren Buffett the opportunity to purchase a stake in the Washington Post Company—an investment that has subsequently increased by more than 100 times the purchase price. That's before dividends are included.

At the time, Buffett said he was buying shares in the company at a deep discount, as evidenced by the fact that the company could have "sold the (Post's) assets to any one of 10 buyers for not less than $400 million, probably appreciably more." Meanwhile, the Washington Post Company had only an $80 million market cap at the time. In 2013, the company was sold to Amazon's billionaire CEO & founder Jeff Bezos for $250 million in cash.

After the Sept. 11 terrorist attacks, the world stopped flying for a while. Suppose that at this time, you had made an investment in Boeing (BA), one of the world's largest builders of commercial aircraft. Boeing's stock didn't bottom until about a year after Sept. 11, but from there, it rose more than four times in value over the next five years. Clearly, although Sept. 11th soured market sentiment about the airline industry for quite some time, those who did their research and were willing to bet that Boeing would survive were well rewarded.

Sir John Templeton ran the Templeton Growth Fund from 1954 to 1992, when he sold it. Each $10,000 invested in the fund's Class A shares in 1954 would have grown to $2 million by 1992, with dividends reinvested, or an annualized return of about 14.5%. Templeton pioneered international investing. He was also a serious contrarian investor, buying into countries and companies when, according to his principle, they hit the "point of maximum pessimism."

At the outset of World War II, Templeton bought shares of every public European company that was trading for less than a dollar, including many that were in bankruptcy. He did this with borrowed money to boot. After four years, he sold the shares for a very large profit.

The Risks of Contrarian Investing

While the most famous contrarian investors put big money on the line, swam against the current of common opinion, and came out on top, they also did some serious research to ensure that the crowd was indeed wrong. So, when a stock takes a nosedive, this doesn't prompt a contrarian investor to put in an immediate buy order, but to find out what has driven the stock down, and whether the drop in price is justified.

Figuring out which distressed stocks to buy and selling them once the company recovers is the major play for contrarian investors. This can lead to securities returning gains much higher than usual. However, being too optimistic about hyped stocks can have the opposite effect.

The Bottom Line

While each of these successful contrarian investors has their own strategy for valuing potential investments, they all have one strategy in common—they let the market bring the deals to them, rather than chasing after them.

Correction—March 6, 2022: This article has been updated to reflect the apocryphal nature of a quotation attributed to Nathan Rothschild.