Contrarian Investing Approach

When the moment is right, will you be ready? A lot of men are about to be. Any time. Any day. Every day, in fact. That’s because the Food & Drug Administration is expected to grant Eli Lilly (NYSE: LLY) approval for a daily version of its erectile disfunction drug, Cialis. This comes after the European Commission approved it in June.

Okay, first things first: Who the heck are these guys married to? Seems to me they have lofty and unreasonable expectations!

But it’s not just in the boudoir where expectations are high. The stock market lives on expectations. And at this time of year, many of them are unreasonable, too. For investors like us, it means we have to navigate a tricky minefield.

Here’s how to do it, I’ve said it here before – and I’ll say it again. I can’t stress to you enough how important it is to have a contrarian investing approach.

The Market Loves Forward Growth Not Past Results

The market is a forward-looking mechanism. Forget “What have you done for me lately?” Investors want to know, “What are you going to do for me tomorrow?” For the most part, stock valuations are based on forward growth and earnings, not on past results.

If you don’t believe me, just take a look at the next time a stock gets crushed – despite meeting or beating analysts’ earnings expectations. If a company does so, but also provides future earnings guidance that is below estimates, it’s Goodnight Irene!

This exact scenario actually happened yesterday to Crocs (Nasdaq: CROX), the makers of those funky foam shoes that everyone seems to be wearing. Propelled by the immense popularity of the shoes, the stock had soared from $37.50 a year ago today to $74.75 on Wednesday.

Happy Halloween, right? Not so much. Shares got absolutely mauled yesterday, plunging $27.01 (36.1%) to close at $47.74.

What could possibly have happened to cause such a drop? Did the CEO get arrested for cooking the books? Did somebody find lead paint in their new pair of Crocs?

Nope. Crocs actually beat analysts’ third-quarter earnings estimates and then raised full-year earnings guidance. Woo-hoo! Break out the champagne! On second thought, keep it on ice. The problem was that Crocs didn’t raise guidance high enough to meet analysts’ lofty expectations.

Tough break for them – and for shareholders. So how do we protect ourselves from unreasonable expectations?

Wanna Cash In? Have A Contrarian Investing Approach

I can’t begin to tell you how important it is to have a contrarian investing approach. If the fickle market loves a stock too much, you can bet that the majority of analysts will slap a fat “buy” rating on it, coupled with pie-in-the-sky earnings projections. They did exactly this for eToys back in the dot com boom days (and I still have the analyst report to prove it) that promised the company would be a “category killer” with huge profit assumptions. But the only thing eToys killed was its shareholders.

But if you invest in stocks that are out of favor, you’re likely to avoid those gut-wrenching 30% falls that result from failing to meet estimates. After all, out of favor stocks already have low expectations. So when they miss estimates, Wall Street simply shrugs it off and says, “What did you expect?” They barely give it a second thought.

But let me tell you something: Those stocks’ declines are far less than their well-loved counterparts.

The Father Of Contrarian Investing

David Dreman is known as the “father of contrarian investing.” And to prove how effective this contrarian investing approach is, he conducted a study that showed stocks with price-to-earnings (P/E) ratios in the bottom 20% (unloved) were down just 0.1% for the full year after they had a negative earnings announcement.

Alternatively, well-loved stocks with P/E ratios in the top 20% endured an 8.9% drop.

While that proves the point, how do we avoid or mitigate the risk that comes from earnings announcements? The simple solution is to use sell-stops. This eliminates emotion from your sell decisions.

Many times, investors freeze up when one of their stocks is plummeting. Emotions and pride take over and they can’t seem to sell while prices are falling. Instead, they wait for the rebound to kick in and end up watching the stock tank further. It’s a great way to lose money.

Use a stop-loss! When you do, the sale is automatically triggered when the stock hits a preset price that you’ve determined in advance (this can be anything – but is usually 20% or 25% lower than your entry price). This way, it’s much easier to cut your losses and move on to the next investment instead of waiting for your stock to bounce back.

But in a stock world where expectations can be so high, how do you get around this without paying over the odds and losing money? There’s a professional strategy for it…

Steer Clear Of Analysts High Expectations

If some analyst has clearly placed overly high expectations on a certain company, you should probably steer clear until the price declines to a more comfortable level for you.

But while most ordinary investors simply do this and then move onto the next candidate, there’s a way you can actually walk away with some money while you wait.

I employed this contrarian investing approach on a flourishing medical device company for Xcelerated Profits Report subscribers in the most recent issue. And my colleague Lee Lowell has also used it twice in recent months.

In my case, I liked the prospects of the company, but because the stock had taken off recently, I argued that there was actually too much optimism. This made buying the stock outright a much riskier bet.
Instead, I suggested selling put options at a lower strike price, thus giving the buyer the right to sell us the shares at that strike price. If the stock retreats to that level, we’ll own it at the lower price we wanted. Not only that, we get to keep the premium that we received for selling the put. And if the stock continues to rise, we still don’t buy it, but we do keep the premium.
Bottom line: We like the company but we don’t chase it when the share price goes up. But we do get free money for trying to own it at the price we want.
Today, the company I recommended issued a stellar earnings report. It really knocked the cover off the ball. However, the stock didn’t rise that much because those expectations I talked about a moment ago were already sky-high.

Find out what this company is here. And if you want to know what this approach is – and how to employ it in your investing – check out today’s “Action Center” below.

Know The Expectations… Know The Limits

When you’re evaluating stocks, make sure you use all your regular methods of due diligence:

Look at the company’s fundamentals,
See what the technicals show you,
Know what projects/products it has and what its future prospects are.
But make sure you also understand what kind of results Wall Street analysts are predicting.
As much as we like to make fun of them for being a bunch of lemmings, it’s their estimates that the Street uses as a guidepost as to whether a company is missing, meeting or exceeding expectations.

Yep, life would be much simpler if expectations were more reasonable – whether we’re talking about individual relationships like a marriage, diplomatic relations between countries or the stock market. But understanding and knowing how to deal with those expectations, especially the unreasonable ones, can keep you out of trouble – with your spouse and your portfolio.

Hoping your longs go up and your shorts go down,

Marc Lichtenfeld