Monday, August 8, 2011

Contrarian Investing - David Dreman

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

My blog of January 17,2011 was titled A Long Wolf Does Not Call Home.  In that blog I discussed the life of a wolf driven from the pack and forced to hunt on its own.  I suggested that an individual investor might pattern his or her investment strategy along the same lines; avoiding the investment crowd to the extent possible and going it alone.

As I said in the last blog, some investors take this idea even further and intentionally invest in a manner opposite to that of the general investment community.  They are referred to as "contrarians."  One of the hallmarks of a contrarian is his or her search for stocks with a low price to earnings ratio (P/E).  A low P/E relative to the overall market is an indication that either the investing public is unaware of the company or is intentionally ignoring it.  The crowd may be ignoring the company because of a general lack of interest in the company (it's not seen as a "hot" stock) or because of a perceived economic weakness in the company or its industry.

Put simply, a low P/E stock is not popular; it is "out of favor" with the Wall Street community.  Contrarians look for these stocks, relying on the fact that sooner or later Wall Street will recognize the financial value of the stock and start to bid up its price as the company or its industry garner investors' attention.  Ben Graham characterized the market in this famous quote, "In the short run, the market is a voting machine but in the long run it is a weighing machine."

David Dreman is considered by many as one of the foremost contrarian investors.  His book, The New Contrarian Investment Strategy, was published in 1982 and remains, to this day, one of the best expositions of this investment strategy.  He was also one of the first authors to explore the psychological underpinnings of investment decisions.  He rejected the efficient market theory that investors always acted rationally.  Today there is an entire field of study called behavioral economics which researches how an individual's psychological makeup can affect and control his or her investment decisions.  Mr. Dreman recounts the results of several psychological experiments which revealed the way people actually approach risk and potential loss.  Some of the research also dealt with the effects "group think" can have on an investor's decisions.

One of my favorite stories from his book is about a mutual fund company, Bull and Bear, Inc. The fund managers wanted to cater to both types of investors in the market at that time.  So, they established two mutual funds: a bull fund for investors who thought the market was going to go up and a bear fund for those who thought the market was going into decline.  Mr. Dreman reported, "Both lost money!  That year, the bull fund declined 15 percent and the bear fund 9 percent."

Mr. Dreman also provided his rules for the contrarian investor.  He agreed with Messrs. Carret, Graham, Frank and Buffet that a company worth investing in had to have a strong economic position with acceptable financial ratios.  He also agreed with Mr. Fisher that a company should demonstrate a rate of earnings growth which exceeds the average earnings growth rate of the market.  He looked for companies with strong records of increasing dividends over time.  He also recommended diversification (equal investments in 15 to 20 different stocks ranging over 10 to 12 industries).

Although each of the previously mentioned authors recommended not overpaying for a stock, Mr. Dreman made a stock's P/E ratio the centerpiece of his investment philosophy.  His primary rule was to buy low P/E stocks listed on the New York Stock Exchange.  He told his readers, "In my own application of the low P/E approach, I have used the bottom 40 percent of stocks according to P/E's for stock selection."  Like Ben Graham, David Dreman was always looking for a cheap stock, as measured by its P/E ratio. By limiting his purchases to the NYSE, he was buying mid to large sized companies.

Mr. Dreman authored several books on contrarian investing, but, to my way of thinking, The New Contrarian Investment Strategy remains his best explanation of this branch of fundamental investing.  Unfortunately, the book is out of print.  You may be able to find copies at your local library or used copies at Amazon.com.

Comments are always welcome.

2 comments:

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