From David Stevenson, across the river from the City

Dear Money Morning reader,

If there’s one piece of investment wisdom that almost everyone knows, it’s that you should invest against the crowd.

Trouble is, because everyone knows it, everyone from fund managers to the bloke down the pub claims to be a ‘contrarian’ - even if their portfolio is little more than a mirror of the FTSE 100 index.

So if everyone claims to be contrarian, how can you tell which stocks and sectors are genuinely out of favour?

The good news is that recent research shows that it’s not too hard to work out where the crowd is investing. The hard part is having the determination to avoid following them...

How to swim against the crowd

Being a genuinely contrarian investor should be easy. Avoid what everyone else is buying, and buy what everyone else is ignoring.

Sounds great in theory - but how do you do it in practice?

First, you should identify shares in which the wider media is very interested, and avoid them. A study published earlier this year by a couple of INSEAD professors, Lily Fang and Joel Peress, measured the performance of US stocks by how often, and how prominently, they were mentioned in the ten years up to 2002 across four American newspapers. The professors also analysed which shares were most dealt in by professional fund managers.

The stocks that got no mentions in the press returned 3% more each year on average than those that attracted lots of attention. What’s more, the best performers of all were small companies with little institutional ownership and limited coverage by analysts. Yet the fund managers still preferred to trade in “high-coverage stocks”, even though these tended to be either small caps in bubble sectors, which often go bust, or big firms, which grow more slowly.

More recent data backs this study up. In this case, it was the banking sector under the microscope. During the 12 months to August 2008, when shares in lenders were really under the cosh, those that featured prominently in the media suffered much more than those that didn’t. Note that in both studies this isn’t about whether the coverage was bullish or bearish – it’s purely about which stocks were drawing all the attention.

Now obviously we all need to do research, and the investment media provides a valuable resource for this. But the message from these studies certainly backs up the classic contrarian view that if an asset class or stock is hitting the headlines of the broadsheet business sections, then opportunities to make money are probably already gone. As Jonathan Compton of Bedlam Asset Management regularly points out, “if it’s in the press, it's in the price”.

Finding sectors to invest in

So we know what to avoid. But how do we find stock market sectors which are out of the spotlight – and so are worth a contrarian look?

One of the best ways of doing this is to measure levels of research coverage. A good way to do this is to take the number of analysts who cover a share and compare that figure with its market cap. The greater the number of analysts relative to a stock’s value, the more ‘over-broked’ it is.

This, as Dylan Grice of Société Générale puts it, is how you’ll find evidence of ‘herd’ behaviour among stock researchers. And herding is bad news for share price performance. “The sell-side” – that’s finance industry-speak for ‘stockbrokers’ – “are as hardwired to herding as anyone else”, he says. “The sectors most loved by them underperform those which are most neglected by them. Less herding = more opportunity”.

And after crunching a mountain of numbers, what are his conclusions?

The real contrarian bet right now

All the top five picks in SocGen’s list are ‘defensive’ sectors (i.e. they contain companies which don’t rely on constant economic growth to make their money), which we’ve been recommending since the market bottomed in March. The energy sector, one of our long-term favourites, features highly, as do consumer staples producers, beverage makers, and drug stocks.

In pole position comes tobacco, where we’ve been keen on British American Tobacco (JSE: BTI). This stock shows good value. At 24300c, BAT is on a prospective PE of below 9 and a current yield of 5.12%. If you’ve no problems with holding cigarette stocks, that must be worth having.

And which ones should you avoid? Well, construction, clothing, and textile companies, all of which can be considered as ‘cyclical’ stocks, (dependent on economic growth), are the top three ‘over-broked’ sectors. That suggests to us that the real contrarian bet right now is to sell the ‘V-shaped’ recovery, and bet on another dip.

Turning to the markets...

The JSE all share index advanced 0.12% yesterday. The gold mining index gained 0.22%. Resources fell 0.17%. Banks and financials grew 1.66% and 1.29% respectively. Industrials pulled back 0.15% and the platinum mining index jumped 0.59%.

London's FTSE100 traded flat, down 0.09%. The Dow Jones collected 0.2% and the Nasdaq fell 0.14%.

Tokyo's Nikkei traded flat, up 0.06%. Hong Kong's Hang Seng added 0.69%.

Brent crude is currently trading at $77.16 per barrel.

Spot gold's trading at $1108.25 and platinum was last quoted at $1359.50.

And here's how the rand is performing against the major currencies:
R/$ 7.38
R/₤ 12.34
R/€ 11.06