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    David Dreman's Contrarian Strategy: Profiting From the Market's "Mistakes"

    by Wayne A. Thorp

    Those who subscribe to the theory of efficient markets believe that the market, as a whole, behaves rationally most of the time. However, most investors know, from experience, that investment decisions can be affected by emotions.

    Contrarian investors seek to understand and profit from the market’s emotional misjudgments by going against the crowd—seeking out-of-favor stocks and avoiding high-flying “vogue” stocks that have been swept up in market euphoria. Eventually, the market rediscovers out-of-favor stocks and lets the high fliers fall back to earth.

    David Dreman is a renowned contrarian investor who has long studied the psychological underpinnings of the overall stock market and its impact on valuation levels. He sees stocks and markets driven by emotions that often push prices from their intrinsic or “fair” value.

    Dreman feels that the best approach to beating the market is to follow the principles of contrarian investing. For many years, Dreman has advocated contrarian investing in books and as a financial columnist. His first book, “Psychology and the Stock Market” was released in 1977. He followed up this work with his 1980 book “Contrarian Investment Strategy—The Psychology of Stock Market Success.” These books are the basis for the AAII David Dreman screen.

    Dreman Screen

    Dreman’s contrarian investment strategy seeks out medium- and large-sized companies with:

    • Low price-earnings ratios;
    • Financial strength;
    • “Reasonable” dividend payments; and
    • Growing earnings.

    You will find the exact screening criteria for the Dreman screen at the end of this article.

    Screen Performance

    Each month, the AAII.com Web site provides a list of the companies passing the David Dreman screen and tracks the performance of these stocks in a hypothetical portfolio.

    Figure 1 illustrates the performance of the David Dreman screen over the period from January 1998 through the end of September 2008. Over the testing period, the stocks passing the screen produced a cumulative price gain of 201.3%, much greater than the S&P 500’s 20.0%.

    Figure 1.
    Performance of
    the Dreman Screen
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    The Dreman screen has experienced three down years over the 10 complete calendar years that make up the testing period. However, year-to-date, the screen is down 16.5%, versus a 20.7% decline in the S&P 500.

    Overview of Passing Firms

    Table 1 highlights some of the characteristics of the companies currently passing the David Dreman screen compared to the typical exchange-listed stock, while Table 2 lists the stocks passing the screen as of October 10, 2008.

    Dreman feels that stocks with high price-earnings ratios are vulnerable if “tastes” change. He also agrees with Benjamin Graham that investors pay too much for companies that appear to have the best prospects at the moment and react too negatively to companies considered to have the weakest prospects. This mistake tends to be a self-correcting process that contrarian investors can use to their advantage.

    As a result, in his own work, Dreman prefers to start the analysis among the bottom 40% of stocks according to their price-earnings ratio. Similarly, the AAII Dreman screen restricts passing companies to the bottom 40% of price-earnings ratios for all stocks in the Stock Investor Pro database, AAII’s fundamental stock screening and research program. As of October 10, 2008, this caps the acceptable price-earnings ratio at 9.7.

    Table 1. Portfolio Characteristics of the Dreman Screen
    Portfolio Characters (Median) David
    Dreman
    Approach
    Exchange-
    Listed
    Stocks
    Price-earnings ratio (X) 7.6 12.0
    Price-to-book-value ratio (X) 1.21 1.07
    Price-earnings-to-EPS est growth (X) 0.6 0.9
    EPS 5-yr. historical growth rate (%) 23.1 13.5
    EPS 3-5 yr. estimated growth rate (%) 12.0 13.9
    Market cap. ($ million) 4,598.5 260.0
    Relative strength vs. S&P (S&P=0) (%) -9 –10
    Monthly Observations
    Average no. of passing stocks 22  
    Highest no. of passing stocks 36  
    Lowest no. of passing stocks 9  
    Monthly turnover (%) 30.6  
    Date as of October 10, 2008.

    The companies currently passing the Dreman screen have a median price-earnings ratio of 7.6, which is lower than the median for the typical exchange-listed stock.

    Genco Shipping & Trading (GNK) has the lowest price-earnings ratio of all the passing companies at 2.3, based on a current price of $16.45 and current earnings per share of $7.21. The company leases drybulk carriers to charter companies for the transportation of iron ore, grain, steel products, and other cargoes. The company also has the highest dividend yield among the companies currently passing the Dreman screen—its 24.3% yield is based on an indicated dividend of $4 per share.

    Companies with low price-earnings ratios are only attractive to contrarian investors if they are expected to grow and prosper going forward. Dreman seeks companies with a higher rate of earnings growth than the S&P 500 both in the immediate past and the immediate future.

    For the companies currently passing the AAII Dreman screen, the average annual earnings increase over the last five years, on a median basis, is 23.1%. This exceeds the median value of 13.5% for the typical exchange-listed stock.

    Looking into the future, the median expected long-term earnings growth rate for the current Dreman companies is 12.0%. Interestingly, this is lower than the 13.9% for exchange-listed stocks.

    Dreman favors large- and medium-sized companies in his approach for three primary reasons—greater chance for a rebound if there is a company misstep, greater market visibility with the rebound, and a reduced chance of “accounting gimmickry.”

    The AAII Dreman screen limits itself to the top 30% of the stock universe in terms of market capitalization. As of October 10, 2008, this results in a market capitalization minimum of almost $360 million. The current group of passing companies has a median market cap of just under $4.6 billion, which dwarfs the median market cap of $260 million for the typical exchange-listed stock.

    The stocks currently passing AAII’s David Dreman screen have underperformed the S&P 500 by 9% over the last 52 weeks. By comparison, the typical exchange-listed stock has underperformed the S&P 500 by 10% over the last year.

    Currently, 28 companies pass the Dreman screen, which is slightly above the monthly average of 22 over the last 10-plus years.

    Another factor Dreman considers with his contrarian investment strategy is one of financial strength. A company with a strong financial position is better able to work through a period of operating difficulty often experienced by out-of-favor stocks.

    Financial strength also helps to provide a measure of safety for the dividend payout. One must consider both the short-term obligations of the company along with long-term liabilities when testing for financial strength.

    The AAII Dreman screen uses the ratio of total liabilities to assets because it considers both short-term and long-term liabilities. Acceptable levels of debt vary from industry to industry, so the Dreman screen looks for companies with total-liabilities-to-assets ratios below the norms for their sector.

    Looking at the passing companies in Table 2, we see that, in general, the financial and utility sectors have higher liabilities-to-assets ratios than the stocks in the basic materials sector.

     

    Conclusion

    When it comes to investing, it is important to distinguish between good companies and good investments. Ironically, the “best” companies often seem to make the worst investments, while the “worst” companies can be the best investments. Too many investors trying to find the next hot stock overbid for the best prospects. Dreman believes that to succeed, you should avoid high price-earnings ratio stocks.

    Like any approach, it must be applied rigorously and patiently for a good chance of success.

    Any stock selection approach requires performing due diligence on screening results. The passing companies represent a starting point—screening allows you to isolate companies with similar quantifiable characteristics, but they may still have underlying problems or issues that exclude them from being good investment opportunities. This is especially true of contrarian investing, when such analysis may help you uncover whether the market is justified in its avoidance of a company or if you have found a solid investment at a discount price.

       What It Takes: The David Dreman Screen
    • The market capitalization for the last fiscal quarter is in the top 30% of the entire database
    • The price-earnings ratio is in the lower 40% of the entire database
    • The total-liabilities-to-total-assets ratio for the last fiscal quarter is below the sector’s median total-liabilities-to-total-assets ratio for the same period
    • The dividend yield is greater than or equal to 1.5%
    • The growth rate of earnings per share from continuing operations for the last 12 months is greater than or equal to the database’s median 12-month growth rate for earnings per share from continuing operations for the same period
    • The growth rate of earnings per share from continuing operations for the last fiscal year is greater than or equal to the database’s median growth rate for earnings per share from continuing operations over the same period
    • The estimated earnings per share figure for the current fiscal year is greater than the reported earnings per share for the last completed fiscal year
    • The estimated earnings per share for the next fiscal year is greater than the estimated earnings per share for the current fiscal year



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