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The Short Answer

How to Be a Contrarian Without Getting Burned

These three tips can help you successfully buy what others are selling.

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Question: I know that some of the most famous investors have been contrarians. But what exactly does that mean, and how do I implement the approach in my portfolio?

Answer: As harrowing as the recent market sell-off has been, widespread pessimism surrounding the economy has been creating opportunities for valuation-conscious investors. For much of the year, Morningstar's equity analysts had considered stocks in their coverage universe to be slightly overvalued. But as a result of the harsh sell-off in the last week, the average stock in our coverage universe is now trading at a more than a 10% discount to fair value, and our analysts think high-quality names such as  Abbott Laboratories (ABT) and  ExxonMobil (XOM) appear to be quite cheap.

Picking up mispriced stocks is a contrarian investor's objective, and such opportunities invariably surface when the market is looking particularly weak. Being willing to purchase out-of-favor stocks, then selling them after their share prices have recovered, can obviously lead to above-average gains. On the other hand, avoiding companies where there is excessive optimism about a stock or sector can help the contrarian avoid market bubbles like the late 1990s technology heyday and the Nifty Fifty era of the 1970s.

As lucrative as a contrarian strategy might seem, executing isn't exactly straightforward. Here are three pointers for going against the crowd without getting trampled.

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Esther Pak does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.