Contrarian

Last modified 09:56, 5 Nov 2012

Contrarian

The Contrarian model is in the Value group of Fundamental Analyses.

Contrarians looks to invest in large, fundamentally sound companies (good earnings growth, good return on equity, low debt-to-equity ratio) that are currently out of favor due to public apathy, delirium or naiveté.

Such companies can be recognized by their low price relative to their Earnings, Cash Flow, Book Value or Dividends.

Analysis / Calculation

The Contrarian approach is first to assess a company as fundamentally sound, and then to determine if it is relatively undervalued. It then goes on to apply a number of additional tests to confirm the company's financial health and stability.

The steps are:

Click on one of the steps above to go to its explanation, below.

Business Quality Analysis

In order to determine that a business is fundamentally sound, the Contrarian model employs the following criteria:

Large Market Capitalization

Large capitalization companies are more likely to be established businesses in the public eye and thus less likely to be susceptible to accounting manipulation. Smaller capitalization companies are often seen as being greater risk as most start-up companies are in this category.

Strong Earnings Stream

A trend of increasingly improving earnings indicates that the underlying business is solid.

EPS Growth Rate Greater than Market's

Both actual and estimated Earnings Per Share Growth Rates for the company are compared to the EPS Growth Rate for the market in general for the same period.  Companies that are growing faster than the market, both currently and in the immediate future, will qualify as quality companies.

Share Price Analysis

The following four criteria are used to assess whether the current market price is undervalued. To be included in the Contrarian results, at least two must be satisfied:

Low Price to Earnings Ratio (P/E)

The P/E ratio is frequently used as an measure of the value of a stock. The belief that low P/E stocks outperform high P/E stocks, while exposing the investor to less risk, is central to Contrarian theory.

Low Cash Flow Per Share (PCF)

Price to Cash Flow is similar to the P/E ratio but many analysts think that using the Cash Flow rather than earnings will give a more accurate picture of a company's true earnings.

Low Price/Book Value (PB)

Another way to measure a company's value against its current share price is to consider the value of its net assets per share and compare it with other companies in the market. The lower the P/B value, the cheaper the assets.

Low Price / Dividend Ratio (P/D)

The Dividend Yield reflects the income that the company distributes to stockholders.  The Price / Dividend Ratio is the full year dividend divided by the stock price and then multiplied by 100 to express the result as a percentage.

The Contrarian model requires the stock to have a dividend yield which is high, meaning the company is able to distribute a relatively large amount of its profits to shareholder.

Additional Financial Strength Indicators

The following ratios are also referred to by the Contrarian methodology in assessing a company's overall financial health:

Strong Current Ratio

This indicates that the company is able to cover its short term borrowings with current assets.

Low Payout Ratio

The Payout Ratio indicates what level of profit is paid out to stockholders as dividends. Contrarians look for companies with low Payout Ratios. This indicates that the company has the ability to pay dividends, but does not. The failure to pay out more in dividends may be part of the reason why its current share price is lower than usual.

High Return on Equity (ROE)

A high Return on Equity figure indicates that the company is making relatively high returns for the money invested in it. Contrarians look to this as an indication that the company's current share price may be undervalued.

Growing Pre-Tax Profit Margin

The Pre-tax Profit Margin is calculated by taking net profit before taxes and dividing it by net sales.

Contrarians are interest in companies with growing pre-tax profit margins as this may indicate that the company is growing sales but at the same time maintaining or improving efficiency.

High Dividend Yield

The Dividend Yield is the full year dividend divided by the stock price and then multiplied by 100 to express the result as a percentage.

The Contrarian Model emphasizes the importance of the ability of a company to raise its dividend. The model requires that a stock should have a high yield that can be maintained, if not increased.

Low Debt to Equity Ratio

The Debt to Equity ratio is calculated by taking total debt and dividing it by shareholders equity.

The Contrarian Model tends towards a conservative view of risk and hence prefers companies to have a total debt to have a relatively low equity ratio.

Note - Banks are not measured using this ratio, they are automatically given a PASS for purposes of the Contrarian model.

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