If contrarian investing was a religion, David Dreman might be its prophet.
If contrarian investing was a religion -- and to many devotees within the Motley Fool community, it is -- then David Dreman might be its prophet.
Background and early career
Dreman was born in Winnipeg, Canada, in 1936, the son of a commodities trader. Following a degree in business administration at the University of Manitoba, he started working as an analyst with his father's firm.
By the mid-1960s he had moved to Wall Street, and was happy to go with the trend of the times, buying into the hot stocks that delivered stratospheric gains. Which was fine, until they suddenly changed direction. "Many of my colleagues not only lost their tenfold gains, but also their initial capital. I was luckier. Having studied market manias, I came out alive, but still left the better part of my gains on the table."
Contrarianism
Dreman's curiosity led him to study the market in greater detail, and the psychological factors that drive it. "Psychology is probably the most important factor in the market, and the one least understood. There's constant overreaction in the market."
As a result of this overreaction, there is profit to be made by going against the prevailing trend. He found that popular stocks were invariably priced higher than they should be, with the result that on the slightest whiff of disappointment the price would plummet. But if the news was good, the price didn't react significantly because that is what people were expecting anyway.
Similarly at the other end of the spectrum: Lowly-valued stocks were expected to do badly, and when they did it was already factored into the share price so they didn't really fall much further. But if they surprised the market with good news, their image changed and their prices rallied.
All that mattered was surprise, and his research showed that surprises were surprisingly frequent. From 1973 to 1996, Dreman found that there was a 37% chance of that results for any given quarter would be more than 5% below analysts' consensus estimates. So looking ahead even a couple of years, the chances of meeting or exceeding expectations every quarter become minuscule. In the UK, most companies report half-yearly rather than quarterly, but the effect is the same. He says "Understanding the nature of surprises provides a high probability method of beating the market."
Investment style
Using this contrarian insight, Dreman targets large companies with below-average valuations, in terms of price/earnings ratio (P/E) , price to book value , price to cash flow, and dividend yield.
Getting on board immediately after a positive earnings surprise, or other 'event trigger' such as analysts' upgrades, is also recommended, assuming the initial valuation criteria are still met.
Dreman will consider selling a share in any of the following circumstances:
- When a share reaches the average market multiple, he may start to sell it over a period of six to eight months;
- If the company doesn't outperform within two-and-a-half to three years, he may lose patience and get out, even if the company still looks attractive; and
- If there's significant bad news, and by that he does not mean a 'normal' miss on quarterly earnings.
Winners and losers
This strategy enabled Dreman to beat the market convincingly throughout the 1990s, while lagging it at the end of that decade when growth stocks were in vogue.
More recently, along with many others, he underestimated the extent of the credit crunch and the effect it would have on the markets. Seeing buying opportunities in the beaten-up financial sector proved to be a mistake -- he had major holdings in Fannie Mae (which he initially bought cheaply during the savings and loan crisis in 1990), Freddie Mac, Washington Mutual, Citigroup, and Bank of America.
"In a crisis or panic, the normal guidelines of value disappear. People no longer examine what a stock is worth; instead they are fixated by prices cascading ever lower. The falling prices are reinforced by expert and peer opinion that things must get worse."
One of his main funds, DWS High Return Equity, lost 47% in one year, putting it in the bottom 3% of its peer group. This fund was founded by Dreman in 1988, and over its first ten years it was the top performing fund in its category. It continued to be managed by him following the sale of his company to Kemper in 1995, and its subsequent takeovers by Scudder, and then by Deutsche Bank's DWS.
But in April, Deutsche Bank finally got rid of Dreman from the fund and decided to manage it in-house (re-naming it the 'DWS Strategic Value Fund'), although they continue to use Dreman's expertise in other funds.
Current positions
Dreman's main worry at present is inflation. In his latest column for Forbes magazine, he says "we are likely to run into a period of wild inflation, at least as bad as what we had from 1979 to 1981 … [because] our Treasury and its counterparts in other countries are printing money around the clock".
He sees equities and real estate as the best bet in an inflationary or even hyper-inflationary environment, and is avoiding bonds. His three favourite stock picks are Apache (oil and gas), Eaton (engineering), and Wells Fargo (banking).
When it was announced that he would leave the DWS fund, it was 29% in energy, and 19% in financials, with its main holdings being ConocoPhillips, Altria, Staples, and Anadarko, which followers of our oil and gas boards will know from its association with Tullow Oil (LSE: TLW).
Despite the recent disastrous performance, Dreman is confident that his strategy will prove correct over the coming years. His yacht is called 'The Contrarian', and while some may ask the obvious question -- where are the clients' yachts? -- his approach may yet prove to be a long-term winner.
Books by David Dreman:
More investing greats:
John Bogle | George Soros | Ben Graham | Jim Rogers | Warren Buffett | Anthony Bolton | Jesse Livermore | Jim Slater | Charlie Munger | Peter Lynch | Carl Icahn | Philip Fisher | Ken Fisher | John Neff | John Templeton | Mark Mobius | Neil Woodford | T. Rowe Price | Bill Miller | Robin Geffen
