Investor Tip: Buy at 'Maximum Pessimism'

Investor Scott Phillips says the best values are in unloved or unknown companies.
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BOSTON (TheStreet) -- The greatest stock-market opportunities are investments that are unpopular, unknown or unpublicized, according to Scott Phillips, a fund manager at Lauren Templeton Capital Management.

Phillips, based in Chattanooga, Tenn., is the author of the recently released

Buying at the Point of Maximum Pessimism: Six Value Investing Trends from China to Oil to Agriculture

, (FT Press, 2010).


spoke to Phillips about the role of contrarian investing and how value opportunities have emerged amid the latest economic crisis.

How important is it, when searching for value and opportunity, to avoid the herd mentality?


: Looking for low valuations will lead to contrarian investments just as easily as looking for contrarian investments should lead to low valuations in the market. I may not set out to only buy securities that have been hastily sold off, become unpopular or are ignored, but if I follow my methods for valuing stocks and only focus on the most attractive valuations, I inevitably end up in contrarian situations.

The greatest opportunities tend to appear where stocks are being avoided. Stocks tend to be avoided because they have become unpopular, or are simply unknown and unpublicized to investors. This is how their market prices become too low in relation to earnings, cash flows, book values and so on.

People often make decisions based on what everybody else is doing or on headlines. How important is it to break this mindset?


: Many investors will struggle with strictly adhering to buying stocks with the most attractive valuations in the market because there is tremendous psychological inertia to doing so. Humans are innately social creatures and base a considerable amount of decision making on observing the behavior of others in the absence of firsthand information. Most often in the stock market, investors receive their information from others rather than do their own homework.

The most recent widespread example of this relationship and its ill effects occurred in the CDO

collateralized debt obligation market during the financial crisis, with credit-rating agencies and the disproportionate amount of trust that investors placed in these firms. When it became clear that the rated assets were not creditworthy, CDO investors had almost nothing to base their decision on for continuing to hold the securities, except what others were doing in the market, and everyone sold in a nearly instantaneous fashion.

In the absence of reliable information, humans rely on "social-proofing" for their decision-making process. If investors see that a stock is being sold off in the market, irrespective of its valuation, they often base their decision on this social proof, or evidence from their peers to also avoid the stock.

Buying stocks with low valuations places a disproportionate emphasis on trusting the numbers on an Excel spreadsheet over the opinions of one's peers. Most people find this psychological inertia too great to overcome, or simply feel more comfortable with a decision when everyone agrees with them.

In all other walks of life, having others agree with you is a good idea. If eight doctors agree on a diagnosis, then it is wise to listen to them. However, if 12 analysts all recommend the same stock, we can be sure it is not a bargain and should probably be avoided.

Does a company like BP (BP) - Get Report, embroiled in controversy, fit the mold as a company to consider buying while it's at a low?


: Without making any type of recommendation whatsoever to buy or sell BP -- and for disclosure purposes, we do not own BP shares -- but yes, it certainly fits the mold of a value investment.

The question all comes down to trying to get a measure on the potential liabilities created by this event. We can be sure that true value investors around the globe are sharpening their pencils and performing analysis on the company and its long-term value in relation to the current share price.

-- Reported by Joe Mont in Boston.


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