The Contra methodology explained

Benj Gallander and Ben Stadelmann
Friday, April 26, 2013

One question that Benj regularly hears on the speaking circuit is, “How do you decide which stocks to buy?” Though the purchases and the reasons behind them are varied, here is the methodology in a nutshell.

The first step is to creates a filter for stocks that have dropped at least one-third over the past 52 weeks. Companies that have existed for fewer than 10 years are then eliminated. These two criteria knock out the vast majority of prospective candidates.

Having passed the initial two tests, the company is then contacted and asked to send the last four annual reports and Form 10-K filings. Though this information can be accessed on the Internet, and much of it is gleaned there, Benj also likes to have this material in his hands to flow through while relaxing on the couch. The amount of mail he receives due to this process is daunting, but fortunately the postmen still seem to like him. Maybe they know that once upon a time he was in their shoes.

After that, the reports of the corporate head honchos are examined. If they consistently predict good times and they have not materialized, then their current and future views are met with more skepticism. However, if they have predicted tough times —and virtually every company that Benj finds is undergoing difficulties, or else it wouldn’t be considered by a contrarian — when their view changes to more positive, their outlook is given more credence.

In the most recent cohort of possibilities, Majesco Entertainment popped onto the screen. This entity, which trades on the Nasdaq with the hip symbol “COOL,” has been badly battered, currently sitting at about 60 cents, down from a high of $2.50 in the past year. In June 2011, it touched above $4.50, which still remains far below where it traded during its heyday over its 20-year existence.

Majesco is a video game publisher for such luminaries as the Microsoft XBOX 360, Nintendo DS and Wii, and Sony PlayStations. This sector has not been booming lately, and that accelerated Cool’s revenue plummet, which registered as a mere $23.5 million in the most recent quarter, a stern spanking from $66.2 million in the same period one year ago.

Normally when revenues tank like this, a huge loss occurs. In this case, the ink was only red to the tune of $2.1 million, a far cry from the black of $7.7 million last year, but not so dreadful, really. A further look at the books shows that the enterprise currently has almost $27 million in the bank, a number that indicates survival capabilities when combined with zero debt. Bankers will not come knocking at the door demanding their tuppence.

Book value exceeds the trading price at 68 cents, with no goodwill inflating the tally, while insiders are reasonably vested, owning 5 percent of the corporation.

This initial perusal is followed by a period of additional information gathering. Historical data will be scrutinized; perhaps a webcast or two will be listened to; corporate emails will be received as they fly through cyberspace, and a general analysis of changes in the video game sphere will take place.

However, the company will not be purchased for a minimum of six months (sometimes a number of years) while a better understanding of future potential, or lack of it, takes place. Possibly, this stock could be acquired in the preferred November/December Contra hunting period, when tax loss season is in full swing and stocks can often be bought at a discount as people dump. In addition, this is just prior to the Santa Claus rally and the January effect, which, though not entirely reliable, are a general positive trend for returns.

While a bid is only eventually placed for a select few, those that make the final cut are anointed with an Initial Sell Target. This is based on where the stock has traded over the past 10 years, with the lower end of the high range normally chosen.

In the case of COOL, a reasonable goal seems to be $2.14. This easily surpasses the minimum 100 percent return that Benj marks for Contra stocks. Worth noting though is that the companies have always traded at that level in the past. Nothing about this is mere hope and conjecture.

There is no question that this is a simplification of the system that Benj outlined in his best-selling book, The Contrarian Investor’s 13. But it does cover a number of the basics to seek and target contrarian stocks. However, buying into unpopular enterprises is certainly not a game that suits the emotions of most investors.

Though a return to the $20-plus level enjoyed in the 2005–06 period is unlikely, something in the $12–$14 range looks achievable. Though the stock has moved up sharply this year to $5.85, there remains plenty of upside for investors who prefer an entry point with momentum on their side.