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Beginners: How to Become an Effective Contrarian Investor

As a contrarian, it pays major dividends to go digging for value amidst the wreckage; however, doing so as a beginner may lead you down the path of “cigar butt” investing, a strategy in which an investor goes looking for the cheapest of stocks without considering the quality of the underlying business. The hope of “cigar butt” investing is that the severely battered names may be too out of favour with the general public and thus has a high chance of a correction to the upside.

The term “cigar butt” was coined by Warren Buffett and comes from the similarities between what the strategy entails and folks who go looking for tossed cigar butts who are looking for one last puff of smoke at no cost to them. While it may seem like you’re paying next to nothing to get something, oftentimes, you may find yourself gravitating toward a value trap if you fail to take proper due diligence with regard to a stock’s underlying business fundamentals.

Just because a stock has fallen by X percent doesn’t mean it can’t continue falling by another X percent or more! Beginners who wish to pursue value investing may find this out themselves as soon as they place a bet on a falling knife or a secularly declining value trap, which is often a black hole with little to no chance of rebounding within a realistic timeframe.

That doesn’t mean new investors shouldn’t invest in battered names though. A great deal can be made from an upside correction if, in fact, an investor is able to tell the difference between a “cigar butt” and the stock of a solid business that’s just encountering tough times.

There’s no rule of thumb to picking stocks that are trading at significant discounts to their intrinsic value. With no shortcuts available, new investors need to be willing to roll up their sleeves and do the homework in order to form a sound thesis, which includes several reasons why a particular stock deserves to be higher than it is.

For example, Alimentation Couche-Tard Inc. (TSX:ATD.B) is the stock of a wonderful business that’s been plagued with a barrage of short-term issues. This has caused shares to become the cheapest they’ve been in recent memory, and for those with a long-term thesis, shares definitely appear to be a wonderful value, as the company is well-equipped to shrug off its recent bout of issues as it returns to the high double-digit EPS growth track.

At 17.7 times trailing earnings, the stock may not seem cheap, but when you consider that you’re getting an earnings-growth gem whose valuation metrics that are well below historical averages, you can feel comfortable that you’re getting a quality piece of merchandise that’s been marked down and not a lemon which may blow up in your portfolio down the road.

Stay hungry. Stay Foolish.

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Fool contributor Joey Frenette owns shares of ALIMENTATION COUCHE-TARD INC. Alimentation Couche-Tard is a recommendation of Stock Advisor Canada.

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