Top 10 contrarian share trades right now

A contrarian strategy for buying quality shares at cheap prices

When markets slumped this summer, highly-respected fund manager Neil Woodford said it was an opening to look for opportunities where the falls had been heaviest. While others were panic selling, Woodford pointed out that good quality companies don't necessarily stop being good when their share prices fall.

While few investors enjoy volatility, momentary dips in prices can be a boon to a strategy that combines two of the most influential drivers of investment returns: quality and value.

This blend of factors has helped earn Woodford a reputation as a star fund manager. It has also driven the success of some of the biggest names in investing, such as David Dreman, Joel Greenblatt and Warren Buffett.

It's a strategy that was summed up by Greenblatt in The Little Book that Beats the Market, when he wrote: "buying good businesses at bargain prices is the secret to making lots of money."

The power of quality and value

Good quality companies with attractive valuations are cast as the stockmarket's contrarians. These are the shares for value investors who are prepared to overlook temporary setbacks or uncertainty.

Often, they don't have the improving price trend that turnaround investors use to find value stocks that are gathering pace. But, equally, contrarian stocks are less likely to be the deeply discounted shares with no quality and no momentum that can end up being value traps.

Instead, contrarian shares need investors to ignore volatility and focus instead on buying quality at a reasonable price. As Warren Buffett termed it: "Whether socks or stocks, I like buying quality merchandise when it is marked down."

The appeal of this approach is that it introduces a safety measure in the hunt for cheaply priced shares. One researcher that has looked closely at this is Robert Novy-Marx, an assistant professor of finance at the University of Rochester in New York.

Novy-Marx's research into the effectiveness of quality and value has found that trading on both signals achieves the double benefit of increasing expected returns while decreasing volatility and drawdowns. He notes: "Cheap, profitable firms tend to outperform firms that are just cheap or just profitable."

How to find a contrarian share

Introducing quality to a value strategy involves defining what exactly is meant by these two factors. Value is always defined relative to price, whether you're using relative measures like price-to-earnings (PE) and price-to-book, or more complex intrinsic value measures like discounted cash flows.

Meanwhile, quality measures often focus on profitability, earnings growth stability, cash generation, pricing power, efficiency and balance sheet health - and an absence of accounting red flags.

Typically, quality is revealed in high operating margins, positive levels of free cash flow and a strong return on capital employed (12%+). It can also be seen in a stock's financial health, which can be assessed using the nine-point accountancy-based checklist known as the Piotroski F-Score.

Screening the market

To get an idea of the sorts of companies that show signs of being contrarian shares, Stockopedia screened the market for Interactive Investor.

The stocks that we find may have hit temporary setbacks, but the quality component of this strategy should provide some insurance against the dreaded value trap. It should help to define the difference between potentially undervalued shares and those that are genuinely cheap for a good reason.

There are lots of ways to screen for contrarian shares - an investor can hunt using some of the metrics mentioned above - but the Stockopedia StockRanks provide a shortcut. We have searched the market for classic quality and value (QV) shares that are showing negative current momentum.

There is no denying that the contrarian nature of these rules picks up stocks that have felt the wrath of the market. Some, like BHP Billiton, languish in depressed sectors such as mining and energy.

Others, like Halfords, Home Retail and Drax carry an element of uncertainty about the future, or may be trying to reinvigorate their business models.

Meanwhile, others, like Rolls-Royce and Aberdeen Asset Management, may have sprung bad news on investors - and are now paying the price.

Given the uncertain nature of contrarian shares, it is essential to investigate them in detail. But this is a strategy that may help to find diamonds in the rough at the very cheapest end of the market. The combination of quality and value adds a greater degree of comfort for investors who enjoy looking for a bargain.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stock market investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

●     To learn more about value investing strategies, you can download the FREE Stockopedia book, How to Make Money in Value Stocks

It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

About the author

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.