David Dreman has long studied the psychological underpinnings of the overall stock market and its impact upon valuation levels.

Dreman sees stocks and markets as being driven by emotions that often push prices from their intrinsic value. Dreman notes 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.

These mistakes tend to be a self-correcting process that contrarian investors can use to their advantage. Stocks with high price-earnings ratios are vulnerable if “tastes” change.

This First Cut applies the David Dreman approach built into AAII’s Stock Investor Pro and presented in the Stock Screens segment of AAII.com.

The stock universe for our First Cut consists of 1,507 stocks among the bottom 40% of stocks according to their price-earnings ratio. This typically provides a broad enough universe from which to perform the complete analysis.

The First Cut then looked for companies with a dividend yield of 1.5% or greater. The yield helps to provide protection against a significant price drop and also contributes to the total return of the investment.

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.” We looked for companies with a market capitalization among the top 30% of stocks.

Dreman notes that a strong financial position enables a company to work through a period of operating difficulty often experienced by out-of-favor stocks, so the First Cut looked for companies with a percentage of total liabilities to total assets below their sector median.

Companies are only attractive if they are expected to grow and prosper in the future. The First Cut screened for companies with short-term growth in earnings greater than the overall database median and that possess expected increases in earnings estimates for each of the next two years.

Nineteen stocks made the First Cut and they are ranked by their price-earnings ratio.

The contrarian strategy seeks to profit from other investors’ misjudgments by seeking out stocks that are out of favor with the market and avoiding the high-flying fashionable stocks that have been swept up by market euphoria.

Eventually the market rediscovers out-of-favor stocks and lets the high-fliers fall back to earth.

—John Bajkowski, president of AAII

David Dreman Screen Ranked by P/E Ratio

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