Review
All stock-market investors embrace the motto “Buy low, sell high.” Few act accordingly, however, for to do so would require that we go against the crowd, buying stocks that are out of favor and selling Wall Street’s darlings. Powerful psychological forces prevent us from pursuing a contrarian investment strategy, although it consistently beats the market, according to David Dreman, a seasoned money manager and long-time columnist for Forbes magazine. One of the Str…
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“Contrarian Investment Strategies: The Next Generation” is an excellent investing book by David Dreman.
Dreman mentions the stock market went nowhere for the seventeen years prior to 1982. This is a reality that many “investors” couldn’t imagine, until recently. Dreman says, “Before all else, a successful strategy requires a strong defense: it must preserve your capital.”
Preservation of Capital is a key factor that many ride-the-hot-IPO investors missed. Many investors are seeking excitement in the “red” room of investing. In “Contrarian Investment Strategies,” Dreman uses a hypothetical example of a casino with two rooms.
One room, the “green” room lacks excitement, but stacks the chances of success in favor of the gambler. Few people are in the green room placing their bets, and the casino manager says it’s a good thing, too, because the casino would go broke if people participated.
The other room is active and exciting, but in the “red” room, the odds are stacked in favor of the casino and people tend to lose. Most investors spend their time in the “red” room of investment because they are seeking excitement. Long-term, this fails to build wealth. Dreman introduces investors to the green room of investing– contrarian investing.
Dreman shows that technical analysis doesn’t work. (So, what else is new? We knew this.) But, then Dreman goes on to examine the performance of professional money managers, most of whom use fundamental analysis.
After allowing for the fact that career pressures and short-term performance demands significantly affect professional stock analysts, Dreman concludes professional fundamental analysts are still bound to fail simply because the great majority of people are very incapable of effectively processing large amounts of data and coming to a meaningful and accurate conclusion about the meaning of the data.
Yet, the more specific information investors are fed, the more confident they become in their predictions of a stock’s behavior and value. Note, we said, they become more confident, not any more accurate.
Effective securities analysis is impossible due to the scope of the endeavor. For example, Dreman casually mentions of Hewlett Packard, “In 1996, it had revenues of over $38 billion and net profit of $2.675 billion and employed 102,300 people domestically and abroad. Foreign sales in 75 countries accounted for 56% of total revenue.” Do you really think you can do fundamental analysis of such a company?
Dreman goes on to show that most analyst’s earnings’ estimates for the next upcoming quarter are usually off significantly and that valuation methods demanding precision are very dubious.
Further, Dreman notes that often company earnings follow their own random walk and that you can’t use the past to predict the future in today’s dynamic economy.
So, what’s an investor to do? Take advantage of the one thing you can be certain of–the chronic overreaction of other investors. Buy out-of-favor stocks, as measured by low price-to-earnings ratios, low price-to-book values, low price-to-cash-flow ratios, or high dividend yields. Surprisingly, Dreman doesn’t mention price-to-sales ratios at all, despite the fact that much evidence supports their use as a great measure of value.
Dreman points out that volatility is not the best measure of investment risk for the investor and he destroys the efficient market hypothesis and that higher reward is correlated with higher risk.
Dreman suggests that one category of stocks, GARP stocks (Growth at a reasonable price), can offer both value (i.e., low risk) and significant appreciation potential. The pharmaceutical stocks of 1993 are an example. These pharmaceutical companies offered significant capital appreciation potential, solid financial positions, and high dividend yields.
Buying out-of-favor GARP stocks “allows you the possibility of a home run, while staying safely in the value camp.”
“Contrarian Investment Strategies” offers an eclectic investment strategy based upon Dreman’s approach to investing. Dreman recommends using some basic fundamental analysis to assure the out-of-favor companies you buy are financially strong.
This book should be read by any serious investor who wishes to move into the “green” room of investing.
Peter Hupalo, Author of “Becoming An Investor: Building Wealth By Investing In Stocks, Bonds, And Mutual Funds”
This is one of perhaps a handful of books the value-oriented investor will likely find indispensable. The book’s indispensability is a product of something for which David Dreman deserves great accolades: his apparent monopoly on an expansive array of statistics –statistics to support buying stocks when they are inexpensive in several different respects, statistics to support the avoidance of stocks priced to perfection, and statistics to support the pathetic fallacy of entrusting valuations and earnings estimates to investment house analysts. The stats compiled by Dreman concerning the latter, especially earnings estimates and a particular issue’s probability of meeting these estimates over serial quarters, are particularly impressive and sobering. At the very least, all of these statistics serve as a validation for what the value investor has at least accepted intuitively. Yet the reader will probably also derive new ways of looking at securities from a value perspective. (Incidentally, readers who are expecting a rehash of the Tweedy Browne value studies will be pleasantly surprised…)
The two additional sections of the book concern investment strategy and investment psychology. Regarding the former, it is hard to cover strategy satisfactorily in value investing without discussing valuation itself. The central challenge of the value approach is distinguishing what’s compellingly cheap from what’s cheap for compelling reason. But here Dreman directs readers to other resources, and coyly suggests buying whatever has the largest number of attractive financial ratios. Thus the newcomer to these approaches will likely have ample reading and work to do if he/she really wishes to seriously embrace the task of finding “oversold” securities.
The investment psychology section is useful, but could probably be reduced by half. In fact, Dreman’s essential shortcoming is his tendency to bludgeon the reader with the same thought, cloaked slightly differently, several hundred times. Of course, in the world of investment literature, there are worse things than relentless proscriptions against doing stupid things in the marketplace.