Warren Buffett made his fortune buying shares in companies that had fallen on hard times and were out of favour with investors, a style of investing called contrarian value investing.
He's not the only investor to have made a mint following a contrarian strategy. Plenty of other investors have followed in his footsteps and generated impressive returns. However, contrarian investing isn't for the faint-hearted. Most investors will shy away from buying a stock trading at a 52-week low for fear of further declines, but that's exactly why the strategy works so well.
Two former retail darlings that have recently fallen on hard times and have slumped to 52-week lows are Marks and Spencer(LSE: MKS) and Sports Direct International(LSE: SPD). The big question is, are these two giants now attractive contrarian bets or should they be avoided?
Sports Direct at first glance looks like a traditional contrarian play. Shares in the company have crashed to a four-year low thanks to worse than expected trading and a bout of negative publicity around the company's founder Mike Ashley. Then at the end of last week, the firm was forced to issue yet another profit warning after a bet designed to protect itself against a slump in sterling had gone wrong, costing it £15m. If sterling remains depressed, management expects full-year profits to take a further £20m hit on top of the £15m charge.
Still, despite the company's problems Sports Direct remains a hit with customers. City analysts expect the group's revenue to increase from £2.9bn to £3.2bn over the next two years and with Mike Ashley, founder and majority shareholder of the retailer back at the helm, many analysts are optimistic about the company's prospects. That said, the company has underlying problems, which are expected to weigh on earnings per share for the next few years.
City consensus expects EPS to slide by a third during the next two years. Based on these figures, shares in the group are currently trading at a forward P/E of 11.5. But with sales still growing, under the right leader Sports Direct's earnings could quickly return to growth, that's what makes the company an attractive contrarian bet.
Marks and Spencer is facing an uphill struggle as the company tries to compete with smaller peers that offer a wider range at a lower cost to customers. And unlike Sports Direct, M&S's sales aren't growing. Specifically, City analysts expect the company's sales to fall by 0.4% this year and over the past five years the company's revenue has only ticked higher by 6.6%. Over the same period, pre-tax profit has increased by 10%.
Current forecasts suggest M&S's earnings per share will fall by 13% this year, which indicates that the shares are trading at a forward P/E of 10.6. This value may look tempting, but considering the company's sluggish growth it's hardly the most appealing valuation around. With this being the case, it looks as if M&S might not be the best contrarian investment, Sports Direct looks to be the better pick.
Not the best income stock
The one redeeming feature of M&S's shares is the company's dividend yield, which currently stands at 6%. But with earnings falling this payout may not be around for long. With this being the case, it could be time to sell M&S and seek out another dividend champion.
One such dividend champion is revealed in this special report. The exclusive report entitled A Top Income Share looks at a hidden FTSE giant that's already an income champion but is also investing for growth and these ambitious expansion plans should power dividends through the roof in the years ahead.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has recommended Sports Direct International. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.