“Being a contrarian for the sake of being contrarian,” says a recent Morningstar article, “is as likely to lead you to investment errors as it is to get you booted off invitation lists for parties.” The article offers insights regarding how a contrarian investing strategy can work best, noting, “the key is to identify environments where market efficiency drops—that is, when investors are behaving irrationally. As valuation-driven investors, we base that identification process on fundamentals and discipline.”

Here are some highlights:

• The article cites research on market efficiency and complex adaptive systems by Michael Mauboussin and others that highlights both the importance of independent investor thinking and behavior as well as group decision-making, that a “crowd predicts better than the people in it.” Using the example of honeybees, the article explains how “collective intelligence” of swarms can find the best outcomes for the group—using the “right mix of interdependence and independence.”
• Research on humans shows that they are heavily swayed by the crowd—something Mauboussin refers to as a “movement from the wisdom of crowds to the madness of mobs.” Investors, it says, “err in the same direction, and contrarians look to take advantage.”
• A dynamic of synchronicity occurs, the article points out, when the breadth of investor types narrows. As a result, market efficiency is challenged as “more like-minded investors use similar decision rules, influenced by each other and not offset by other investors.” This can lead to herding behavior, the article argues, and increase the fragility of markets.
• The article offers a “checklist” of metrics to look for as part of a contrarian investing strategy. The list includes: negative cash flows or earnings expectations; negative sentiment, and low trading volume or turnover.

“Just because something is unpopular doesn’t make it a good investment,” the article concludes. “Combining contrarian thinking with in-depth fundamental analysis and estimated intrinsic value is critical.”