It is an approach to investing in which the investor takes position about the market in a direction opposite to the prevailing market trend. So, if the market is moving upward, the contrarian investor would take the view that it has become overvalued and would soon start coming down. So, instead of buying the stock, he would be selling them. Similarly, if the market is moving down, the contrarian investor would take the view that it would soon be into the oversold zone, i.e. undervalued, and in a matter of time, would start moving up. The scope of the contrarian investing could be stock-specific, sector-specific, or the market-wide, based upon the views of the investor.
Contrarian investors usually look for stocks which are in process of or have become undervalued or overvalued due to some reasons like price movements based upon positive or negative news. While most of the investors, due to their herd mentality, would still be buying or selling on the expectation of the further continuation of the price movement, contrarian investor would be looking for values above or below which the stock would become overvalued or undervalued. And, he would take long or short position based upon this assessment even if most other investors are taking opposite positions. Generally, there are two types of contrarian strategies: prior returns strategy and valuation measures strategy.
Prior returns strategy assumes that extreme price movements in one direction will be followed by subsequent extreme movements in opposite direction. So, past losers are expected to become future winners. The logic underlying this proposition is that stocks which have performed well in past are bid up by the investors in over-reaction to ultimately become overpriced. Similarly, the stocks having fared poorly in past are oversold to the limit of becoming undervalued by the over-reacting investors. The contrarian investors assess the time of arrival of the two extremes to take their positions.
In valuation measures strategy, the ratios like price-to-earning, price-to-book value, book-to-market value etc. are either expected to be a proxy for past performance or to disclose the future performance expectations of the stock. The contrarian investor chooses only those stocks which are either over-valued, or undervalued, or have potential future upside or downside.