A Surprising Opportunity

Contrarian investment Rule 10 positioned us in out-of-favor stoclcs to take advantage of analysts forecast errors and other surprises. We can now go further in delineating the effect of surprises, which will prove an essential tool for the strategies to be oudined shortly. Rule 12 summarizes our findings on surprise:

RULE 12

(A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.

(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal Impact on favorites.

(C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.

(D) The effect of an earnings surprise continues for an extended period of time.

In this chapter, we have examined the role of surprise and have found that it consistently favors stocks that investors believe have poor outlooks and just as consistently works against those believed to be la creme. Because of the frequency of earnings surprises demonstrated in the last chapter, we know it is a powerful force acting to reverse previous over- or undervaluations of stocks.

Just how important surprise and the resulting change in investor expectations are in developing powerful investment strategies will be shown front and center in the next chapter. Its time to roll up our sleeves and sit down at a table in the green wing.

PART m

THE WORLD OF

CONTRARIAN

INVESTING

Contrarian Investment Strategies

HEN the British marched out to surrender to General Washington and his French allies at Yorlctown, scabbards pointed up and rifles pointed down, their military bands played a popular tune of the day, "The World Turned Upside Down." And so it must have seemed to this crisp, smartly dressed army surrendering to a ragtag militia from these insignificant colonies. How could the most powerful nation on Earth be reduced to such an ignoble outcome? Many a money manager and other professional investor immaculately dressed in Armani suits, in their well-appointed offices, flanlced by the latest and most powerful maricet technology of the day, must wonder the same thing. How can they have performed so dismally, when they buy the top research and investment advice, which naturally must lead them to the "best" stocks? Its a real puzzle.

But... are the stocks the experts like really the ones to buy? We have seen that the answer is a strong no. The favorite stocks of analysts and money managers were consistendy punished by earnings 8 8 8, while the stocks nobody loved or wanted just as consistently benefited from them. Investor enthusiasm often results in popular stocks becoming ove riced, while the lack of it dumps them into the bargain basement. Earnings and other 8 18 8 result in a reevaluation of both groups and more realistic pricing.

This is certainly a large, critical piece of the puzzle, but how do we fit it into a practical investment strategy? After all, were notjust trying to analyze market dynamics, were seeking to learn how to profit from them. For a change, rather than trying to build a deductive case, Im going to put the answer right on the table for your inspection. While Im at it, we should go ahead and make the next contrarian investment rule.