SocioEconomic Challenges (Jul 2024)
Does Contrarian Investing Beat the Conventional Strategies and the Index?
Abstract
Traditional momentum strategies on the stock market are implemented in accordance with the efficient market hypothesis and involve making investments in accordance with market trends. However, this hypothesis has been repeatedly criticized by supporters of behavioral finance, who allow the irrational nature of investment decisions, which led to the emergence of contrarian investment strategies, based on the overreaction hypothesis and the reversal effect (over a longer horizon, loser stocks outperform winners), according to which investments are made in opposite direction to the market, involves buying the losing stocks and selling the winners. According to contrarian investment strategies, when buying shares, investors prefer a lower level of P/E ratios (Price – earnings ratio), which indicates the valuation multiple placed to the company’s market price vis-à-vis its net profits. The article examines the hypothesis that P/E ratio and contrarian investment are related, based on data for 2010–2022 for 50 shares of India, whose stock market is developing rapidly, examines the differences between the top ten P/E stocks and the bottom ten P/E stocks using inflation adjusted return on investment (ROI) to determine, whether or not, an investment in such stocks would generate sufficient returns to outpace inflation over a period of ten years. The article tests 3 hypotheses that investing in stocks with low P/E ratios in the Nifty 50 index (a live benchmark that illustrates how each industry contributes to India’s GDP) will generate higher returns than investing in stocks with high P/E ratios, over a long-term horizon (H1), inflation (Н2), the Nifty 50 index (Н3). The sources of data were finalized to be BSE Official Website, NSE Official Website, Yahoo Finance, Screener, Annual Reports, etc. The article calculates the profits for top 10 P/E stocks (conventional strategy) and bottom 10 P/E stocks (contrarian investing), and determining the returns from top 10 P/E stocks and the bottom 10 P/E stocks (when calculating for 10 years, the same steps were repeated: synchronously, once a year, both types of shares were bought at Purchase Price and sold a year later at Market Price). The calculations confirmed all 3 proposed hypotheses. Contrarian investing delivered returns of around 3.64 times the initial investment, whereas conventional investing produced returns of about 77.5% when comparing the top 10 P/E stocks to the bottom 10 P/E stocks in the Nifty 50 index. An outstanding return of 84.11%, which is a strong return when adjusted for inflation, was achieved using the contrarian strategy. As a result of the conventional strategy’s loss of 10.45% when adjusted for inflation, the study also shows that contrarian investing can assist an investor in hedging against inflation. This emphasizes how crucial it is to take a contrarian attitude when making stock market investments. At the same time, contrarian investment returns of 3.64 times the initial investment over this period surpass the benchmark Nifty 50 Index returns, which is 3.24 times.
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