Embracing Contrarian Investing

 | Sep 12, 2013 | 10:00 AM EDT
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Contrarian investing requires due diligence, patience, discipline and the willingness to go against the crowd. Most of all, it takes courage and conviction. While the market is chasing up momentum plays like Netflix (NFLX) and Tesla Motors (TSLA), a contrarian has to be willing to catch a "falling knife" every now and then.

The upside is that it can yield lucrative long-term returns if done right. My approach to this strategy is to research a falling stock and/or out-of-favor sector carefully and thoroughly before initiating a small position. If the stock or sector continues to fall, I will redo my research to ensure my original thesis still seems to correct. If it is, I have no problem doubling my position.

Two stocks in my portfolio demonstrate how I use contrarian investing to enhance my returns. Both fell significantly below my entry point. I also re-examined my bull case on both before doubling my stakes and both are now happily heading up.

Linn Energy (LINE) is an energy partnership that develops and produces natural gas and oil and pays more than a 12% yield. The company has come under fire from some shorts. It has also been the subject of some unflattering articles in Barron's that questioned some of its accounting practices. These worries were deemed to put its merger with Berry Petroleum (BRY) in peril.

I first started accumulating the shares at just above $30. When the stock fell to the low $20s, I re-examined the bullish case on the shares. Its "questionable" accounting practices seem pretty standard in the industry and some noted value investors, including Goldman Sachs, came out with favorable comments on the partnership. I doubled my position.

The shares have rallied hard since then, including a better-than-12% rise on Wednesday when the company issued a positive progress report around the merger with Berry Petroleum. It is also acquiring additional acreage in the Permian basin that should be immediately accretive to distributable cash flow. Even with the recent rally, LINE is $10 a share below its highs earlier in the year and I think it will move up from here.

RAIT Financial Trust (RAS) is another contrarian play that made a big move Wednesday after announcing it will again raise its quarterly dividend by $0.02 a share to $0.15. The reason the stock has been under pressure moving from my initial position of $7.60 a share to below $6.40 a share where I doubled my position is straightforward. Like most REITs in this space, it has moved the opposite direction of interest rates which have been on the rise recently.

However, unlike the mortgage REITs most investors have lumped it in with, RAIT also owns and manages some properties. This decreases its earnings volatility compared to pure mortgage REITs. With the new dividend increase, the REIT will yield north of 8.5% even after the 8% rally in its stock on Wednesday.

RAIT Financial Trust is selling below book value and investors are probably not giving the company its due for the value of its investment portfolio of commercial properties. In addition, as interest rates stabilize the REIT should benefit when funds come back into the sector looking for yield.

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