With financial pundits, investment advisors, and even friends or neighbors, constantly barraging us with news of the latest "hot" stocks, its more important than ever to use a fundamental, stick-to-the-numbers approach when investing. This need to take emotion out of the equation and to focus on a stock's underlying fundamentals is a main reason why I developed my "Guru Strategies", computer models that are each based on the investment philosophy of a different Wall Street great.
But as important as the numbers themselves are, it's sometimes equally interesting and useful to understand where they come from. And when it comes to David Dreman, the beliefs behind the numbers are particularly fascinating. Dreman is a great student of human psychology. He believes that most investors -- including professional investors -- get caught up in a pattern of predictable, emotional errors that are so systematic that a knowledgeable investor can take great advantage of them. This belief has led him to become perhaps the best known "contrarian" investor in the world, shunning conventional approaches and picking stocks that are often ignored by the rest of the investment community.
It's a method that Dreman has used with great success. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking as the best of 255 funds in its peer groups from 1988-1998 according to Lipper Analytical Services. At the time Dreman published Contrarian Investment Strategies: The Next Generation (the book upon which I base my Dreman model), the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database. Here's a look at my Dreman-based model, and at the intriguing insights into investor psychology that shape Dreman's approach.
Redefining risk
Before I get into the specifics, there is a broad concept that is a critical part of Dreman's investment philosophy: The stock market, he believes, is far and away the best investment vehicle available to most investors. This idea is so important to Dreman that it is a major part of how he redefines the concept of risk as most investors know it.
Traditionally, investors view "risk" as being synonymous with "volatility"; they believe that to get higher returns, they must be willing to stomach higher volatility in a stock's price. Dreman, however, believes that using monthly or quarterly volatility as a measure of risk just doesn't make sense when investors are -- or at least should be -- investing for time horizons of five years, ten years, or more. To him, the biggest risk is not short-term volatility, but the possibility of not reaching your long-term investment goals. And the greatest enemy to reaching those goals: inflation.
"For example, if you buy a bond that earns 5.5 percent per year over 10 years, and inflation is creeping up at, say, 3 percent per year, the real value of your investment will end up being significantly less than 5.5 percent greater than the price you paid for it when you cash out."
According to Dreman's research, inflation has taken a major bite out of fixed-return investments over history. In fact, inflation-adjusted returns for stocks -- which, unlike bonds or T-bills have the ability to produce increasing earnings streams -- have consistently outpaced those of bonds and Treasury bills since the start of the 1800's. That gap has widened since the mid-1920's, when inflation began to have a more significant impact.
Dreman's bottom line: In the short-term, stocks are unpredictable, so if you're saving to buy a house or a car within the next two years or so, bonds and T-bills are a good choice. But in the long-term, history has shown that the safest choice is the stock market, which has consistently outperformed fixed-rate investments in long-term periods for more than two centuries. "Indeed, it goes against the principle we were taught from childhood -- that the safest way to save was putting our money in the bank," Dreman says.
Target large growth stocks
When it comes to the specifics of my Dreman-based model, the first step is to identify large stocks with good recent earnings. Dreman believed such companies are more in the public eye, less subject to accounting gimmickry, and tend to have more staying power. My model does this by looking only at the 1,500 largest stocks, based on market capitalization.
In terms of earnings, Dreman liked companies whose earnings per share (EPS) for the most recent quarter were greater than the EPS for the preceding quarter. He also liked firms whose EPS growth rate was higher than the S&P 500's growth rate in the near past, with the likelihood that the trend would continue in the future.
An example of a company that shows these characteristics is Royal Dutch Shell (NYSE:RDS.A). The Netherlands-based energy giant has a market cap of $267.2 billion, which easily puts it among the 1,500 largest stocks. In addition, its EPS in the most recent quarter were $1.38, up from $1.16 in the quarter before that, showing the kind of increasing earnings trend Dreman liked. Shell's growth rate over the past six months, 66.26 percent, is also well beyond that of the S&P 500, which has decreased by 1.15 percent. And Shell's EPS is expected to grow by 109.87 percent in the current year, which means it should continue growing faster than the S&P, passing yet another Dreman-based test.
Get contrarian
When it comes to investor psychology, one of Dreman's most important findings was that investors tend to overvalue the "best" stocks -- the "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague. He also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. What's more, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.
What does all that mean? Well, because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. On the other hand, because they already tend to be undervalued, the "worst" stocks don't have much further down to go when bad surprises occur. When good surprises occur, however, they have a lot of room to grow. Dreman's conclusion: Be a "contrarian" -- that is, target those stocks that are out of favor with the market, and you have a much better chance of realizing gains.
To do this, Dreman compared a stock's price to four different fundamentals: earnings, cash flow, book value (tangible assets minus liabilities), and dividend yield. If the stock falls into the bottom 20 percent of the market in two or more of those areas (price/earnings, price/cash flow, price/book value, and price/dividend yield), it is considered contrarian. Essentially, investors are undervaluing the company based on its fundamentals.
Let's look again at Shell as an example. While oil companies have been producing incredible profits lately, many investors are still leery of the industry. A recent Washington Post article notes that some analysts are predicting that huge costs involved in oil extraction and refining could soon cut big oil's profits substantially. That may be part of the reason that investors haven't been as keen on Shell as you'd expect considering its huge recent profits. The firm's P/E, 9.74, and price/cash flow, 6.49, are both in the bottom 20 percent of the market, which qualify it as an undervalued contrarian stock using my Dreman-based model.
Fundamentally sound
Of course, it's not enough that a stock is contrarian. After all, there may be valid reasons that other investors aren't willing to pay more for it. So once he had identified contrarian stocks, Dreman looked at as many financial variables as possible to try to be sure that they weren't selling on the cheap because of problems with the company. A few examples:
Current ratio This is a company's assets minus its liabilities, which is a sign of its ability to pay off its debts. A stock's ratio should be greater than or equal to the average of its industry, or greater than 2.0. Shell has a current ratio of 1.26, which is better than the oil and gas industry's average of 1.22, passing this test.
Return on equity My Dreman-based model takes the 1,500 largest stocks and ranks them in terms of ROE. To pass this test, a company's ROE must be greater than the average ROE for the top third of those stocks, which is an indication that there are no structural flaws in the firm. The model considers anything over 27 percent to be staggering. Currently, a company would have to have an ROE of 21.01 percent to pass this test; Royal Dutch Shell, with an ROE of 25.53 percent, makes the grade.
Pre-tax profit margins Dreman liked this figure to be at least 8 percent, and considered anything over 22 percent to be phenomenal. At 14.34 percent, Shell again makes the grade.
Dividend yield My Dreman-based model requires a company's yield to be greater than the market yield, which is currently 2.35 percent. At 3.42 percent, Shell again gets high marks.
Payout ratio Dreman also liked it when a company had the ability to raise its dividend payouts. One way to measure this is by comparing its current payout ratio to its historical payout ratio; if the current figure is less than the historical figure, that's a good indication that the company could raise its dividend in the future.
Currently, Shell's payout ratio is 32.24 percent, below its historical payout ratio of 39.16 percent, so it passes this test.
In addition to Shell, here's a look at a few other companies that pass my Dreman-based model:
AllianceBernstein (NYSE:AB): This New York-based firm manages close to $800 billion in assets, and has been one of the largest foreign investors in Bank Hapoalim, Israel's largest bank. AllianceBernstein's low price/cash flow (5.95) and low price/dividend ratio (18.35) -- both of which are contrarian indicators -- may be a result of the fallout from mortgage and credit crises in the U.S. financial sector. But despite those crises, AllianceBernstein appears to be on strong financial footing, with a 30.56 percent pre-tax profit margin that my Dreman-based model considers phenomenal, an impressive 5.45 percent yield, and a 23.65 percent return on equity.
BP (NYSE:BP): This U.K.-based energy giant ($226.5 billion market cap) gets contrarian status because of its 8.94 P/E ratio and 6.03 price/cash flow ratio, which again may be a result of skepticism about whether big oil can continue its big profits -- not to mention worries about several recent fires at the company's Alaska facilities. Nonetheless, BP's financials indicate that it is being undervalued -- it has a 30.55 percent return on equity, which my Dreman-based model considers staggering, pre-tax profit margins of 14.43 percent, exceeding this model's 8 percent minimum, and a current payout ratio (30.5 percent) that is substantially less than its historical payout ratio (43.86 percent).
Barclays (NYSE:BCS): Barclays is another U.K.-based company, but today the banking giant gets about half of its profit from outside its home country. Its stock price has taken some hits because of the recent mortgage and credit problems in the U.S., which is reflected in its low P/E (8.49) and price/cash flow (6.99) ratios. Still, Barclays' pre-tax profit margin -- 32.72 percent -- is in that "phenomenal" range, according to my Dreman-based method, and its 25.14 percent return on equity also makes the grade, showing that it may be unfairly maligned.
Staying strong
Like some of the other strategies I've discussed in past columns, Dreman's contrarian approach is difficult to follow not because of the specifics of the strategy, but because of the emotional fortitude it requires. Remember, these are stocks whose reputations or prices have taken hits, and hearing continually from the media about their problems can make you want to follow the rest of Wall Street and jump ship. Says Dreman, "The success of contrarian strategies requires you at times to go against gut reactions, the prevailing beliefs in the marketplace, and the experts you respect. … In practice … it's a nightmare. I kid you not, nor do I exaggerate. That is the bottom line of why contrarian strategies are so rarely followed."
Indeed, to follow my Dreman-based model you need to have the conviction to stay the course when seemingly everyone is doing the opposite. But take it from me, there's method to the madness: My Dreman-based strategy has consistently been one of my top performers, gaining 176.8 percent since its inception four years ago, more than tripling the gains of the S&P 500. If you have strength to stick to a solid strategy like this, your portfolio should also reap the benefits.
Update: Warren Buffett
The New York Times reported last Thursday that Warren Buffett is among those interested in purchasing a minority stake in troubled U.S. investment giant Bear Stearns (BSC). The company, which this summer shut down two hedge funds that were devastated by the subprime mortgage fallout, is trading at about 40 percent below its high, so it's no wonder the famous value investor is seeing opportunity.
Interestingly, the computerized investment model that I base on Buffett's approach has little interest in Bear Stearns, or any of the other major investment banks. It is, however, finding value in a couple lesser-known companies in the financial industry, including SEI Investments Company (SEIC), A.F.P. Provida (PVD) of Chile, and Franklin Resources (BEN).
Published by Globes [online], Israel business news - www.globes.co.il - on October 2, 2007