The philosophy and investment style of David Dreman was examined in the November 2015 issue of the AAII Journal. Here we derive quantitative metrics from David Dreman’s contrarian approach and implement them into a stock screen to arrive at a list of prospective stocks that may warrant further analysis. AAII’s Stock Investor Pro fundamental stock screening and research database program was used to create the Dreman screen.

David Dreman’s contrarian investing approach involves avoiding the high-flying stocks that the market is most optimistic about and purchasing the stocks that are out of favor with the market. Essentially, a contrarian goes against the crowd.

Dreman’s books often cite research from academic studies proving that humans take “mental shortcuts” when making decisions. While mental shortcuts have benefits in our day-to-day lives, they affect us when it comes to investing.

Stock Universe and Primary Criteria

Low Price-Earnings Ratio

The price-earnings (P/E) ratio is a function of investor expectations. If investors expect that a stock will outperform its peers, they are willing to pay a higher price for a given level of earnings. A growth stock’s price (numerator) is pushed up much faster than its earnings (denominator), due to high expectations of future earnings performance, causing the price-earnings ratio to become inflated. Dreman explains, “companies with the best earnings prospects and fastest growth rates are normally accorded higher P/E ratios, while companies with poor or lackluster prospects are banished to the lower-multiple tiers.”

Forecasting and estimation is at the heart of security analysis. For expectations to be met, forecasts would need to be extremely accurate. Dreman’s research proves that analysts’ recommendations and growth projections are often not only incorrect, but too optimistic.

 Popular growth companies tend to have higher price-earnings multiples and, according to Dreman, underperform the market in the long run compared to the lower price-earnings universe. This is due to the market’s overreaction when growth companies fail to meet inflated expectations and the change in perception that occurs when an out-of-favor stock beats estimates. Growth stocks are often vulnerable to changes in “tastes” in the market. Investors will often switch from one industrial segment of the market to another that is better positioned for the current market environment, a practice called sector rotation. This psychological rotation is often quick and dramatic.

Dreman’s contrarian approach begins with selecting stocks in the bottom 40% of stocks according to their price-earnings ratio. This low price-earnings group represents stocks that are out of favor with the market. Investors are not willing to pay a higher multiple for a share of these stocks, whether because of poor earnings, low growth estimates or recent downward analyst revisions and recommendations. Dreman asserts that there are stocks in this low price-earnings universe that do not deserve the lower multiple and that will subsequently outperform the market once investors realize the stock’s undervaluation.

Dreman emphasized that it does not matter whether an investor starts investing near a market top or a market bottom; superior returns are provided in any phase of the market cycle. There are periods of underperformance for both the high P/E price-earnings group as well as the low price-earnings group, making it important to follow this methodology over the long term.

Mid- to Large-Cap Companies

Dreman feels that mid- to large-sized companies are subject to less accounting gimmickry because they are more “in the spotlight” and forced to comply with more rules and regulations than smaller firms. He refers to accounting as a “devilishly tricky subject.” Even though most firms are required to adhere to generally accepted accounting principles (GAAP), a great deal of discretion can be used by management to manipulate timing and classification of revenue and expenses. While any company’s earnings are somewhat subjective, Dreman points out that mid- and large-sized companies are generally more scrutinized by investors and analysts than smaller firms.

Contrarian stocks are often stocks of companies that have hit a rough patch and are subsequently oversold in the market. Because mid- and large-sized firms are more in the public eye, a “turnaround” of company operations is more likely to be well-publicized. This allows contrarian investors to profit from the change in perception that occurs when the market hears this news. Eventually, the market is willing to pay more for a given level of earnings, resulting in a higher valuation. An increase in earnings coupled with an increase in the multiple investors are willing to pay for a given level of earnings translates to significant price increases.

Dreman does not identify a specific cutoff for determining acceptable company size, leaving the decision to the discretion of the investor.

To determine the cutoff for our Dreman screen, we examined market capitalization levels (share price times number of shares outstanding). If you limit yourself to the top 10% of companies, you would be examining companies with a market capitalization of at least $8.9 billion. This is a reasonable limit for capturing large companies, but for our screen we also wanted to capture a greater number of medium-sized firms. A cutoff of 20% results in a market capitalization minimum of approximately $2.9 billion, while a 30% cut-off provides a $1.3 billion floor. To help provide for a wider cross-section of passing companies, we made this filter aggressive and used the 30% cutoff. As an independent criterion, 2,104 companies passed the filter using data as of October 30, 2015, and when combined with the price-earnings criterion, a total of 543 companies passed both filters.

The median market capitalization for the passing companies is $4.9 billion, well above the $284 million for all listed stocks as covered in Stock Investor Pro.

Secondary Criteria

David Dreman is not a fan of fundamental security analysis; however, he does make it clear that investors shouldn’t abandon fundamental research entirely. He identifies criteria that will help select stocks from the low price-earnings universe that are most likely to provide long-term returns above the market.

Financial Position

Dreman feels that a contrarian stock should have a strong financial position. This will enable a company to weather periods of operating difficulty, which low price-earnings stocks sometimes experience. A strong financial position also helps to ensure the safety of a company’s dividend payment.

There are several financial ratios used to analyze a company’s financial strength, including the current ratio (current assets divided by current liabilities), debt-to-equity ratio (total debt divided by owner’s equity), interest coverage ratio (earnings before interest, depreciation and taxes divided by interest expense) and liabilities-to-assets ratio (total liabilities divided by total assets).

Dreman does not identify a specific measure of financial strength. We feel that it is important to analyze both a company’s short-term and long-term obligations, which is why total liabilities to assets was used in the screen. Alternatively, we could have used two ratios, one that looks at short-term obligations (the current ratio) as well as a long-term measure of financial strength (debt-to-equity ratio).

Table 1. Liabilities-to-Assets Ratios by Sector

Acceptable levels of debt and financial leverage vary between sectors and can differ depending on a company’s line of business and its stage of development. Therefore, the screen seeks companies with total liabilities to assets below its sector norms. As you can see in Table 1, the median (which excludes outliers) liabilities-to-assets ratio is greatest for the financial sector, while the average liabilities-to-assets ratio is highest for the energy sector.

This filter cut the number of passing companies down to 244.

Dividend Yield

Dreman seeks companies with a high dividend yield that can be sustained and possibly raised. The sustainability of the dividend is supported by the total-asset-to-liabilities ratio mentioned above.

The high yield should provide protection against significant price deterioration as well as be an important contributor to total return (income return plus price return). Screening for dividend yield also reinforces the fact that we are looking for mid- to large-sized companies because it is typically the larger, more stable firms that tend to pay dividends.

Dividend yield (as well as many other metrics) can be screened for in two ways. It can have a desirable absolute level or relative level. An absolute level requires a specific yield amount, whereas a relative yield compares the current yield to the market level or to the company’s historical norm.

If an absolute level of yield is specified in a screen, it cannot be too high or only companies from industries that traditionally pay high dividends will pass. The median yield for companies in the S&P 500 is 2.0%. In order to allow a wide range of industries to pass while also seeking a meaningful distribution, the Dreman screen requires a minimum yield of 1.5%.

The filter cut the number of passing companies down to 171.

To get a full picture of whether a company can sustain and/or raise its dividend distribution, it is helpful to examine the passing companies’ dividend payout ratio and dividend growth rate.

The payout ratio is calculated by dividing the annual indicated dividend by earnings and indicates what portion of earnings are being paid out to shareholders. Companies in defensive sectors tend to have stable and predictable earnings and cash flows and thus can support a higher payout ratio, while companies in cyclical industries typically have lower payout ratios since their cash flows and earnings fluctuate with economic cycles. Generally speaking, a payout ratio above 100% is not sustainable and indicates that the company is paying out more in dividends than it makes in net income. Investors should seek a positive payout ratio of 50% or less for all non-utility companies and 80% or less for utility firms.

Table 2. Stocks Passing the Dreman Contrarian Screen

For a current list of passing companies, click here.

While the past is not always a safe prediction of the future, it is useful to examine a company’s dividend growth rate to see if increasing dividends is part of company policy. Dreman doesn’t require dividend growth per se; however, he mentions looking for firms that can “sustain and possibly raise” their distributions.

Table 2 presents the payout ratios and three-year dividend growth rate of the passing companies.

Earnings Growth

While contrarian investors are seeking stocks with P/E ratios in the bottom 40% of the stock universe, that doesn’t necessarily mean that they should be looking for stocks with weak prospects. Dreman’s approach seeks companies that are mispriced in the market and don’t deserve their lower valuation, meaning there must be reason to expect that these stocks’ valuation will improve over time.

Dreman seeks companies with a higher rate of earnings growth than the S&P 500, both in the immediate past and projected into the near future. Because Dreman feels that earnings are nearly impossible to estimate, he doesn’t outline a specific level of earnings growth, but instead encourages investors to merely note the general direction of earnings.

He points out that if an investor’s projection of earnings growth is wrong, there’s probably little downside risk, since the market has already discounted the worst, but if the projection is right and earnings are growing faster than averages, the stock may well outperform the lower price-earnings groups in general. Dreman asserts that earnings estimates should lean to the “conservative side.” By analyzing only general forecasts and keeping them conservative as opposed to looking at specific earnings estimates, the chance of error is reduced.

To properly assess the general direction of earnings, the screen seeks companies with short-term growth in earnings greater than the overall database median and requires expected increases in earnings estimates for each of the next two years.

Continuing earnings are used in the screen because they better represent a company’s typical operations and exclude one-time expenses.

Table 3. Passing Companies’ Earnings Per Share Figures

Table 3 presents the earnings from the last fiscal year and historical annualized continuing earnings per share growth over the last five years along with the consensus earnings estimates for I/B/E/S for the current year, next year, and over the long term, to help provide a sense of the market expectations embedded in the stock price.

Collectively these screens reduced our list to the 19 stocks presented in Table 2.

Non-Quantitative Aspects of David Dreman’s Approach

When implementing any stock investing strategy, realize that not all aspects of the approach are quantitative and therefore can’t all be implemented into a stock screen.

David Dreman recommends equal investment among 15 to 20 stocks, diversified among 10 to 12 industries. He feels that diversification is essential to conduct the low price-earnings strategy properly. A single stock’s returns can be very volatile, making it dangerous to rely solely on one holding’s performance. Spreading the risk allows investors to better mimic the average return for the price-earnings quintile(s) chosen.

Dreman’s studies show that the low price-earnings approach works best over longer holding periods. The ultraconservative investor should apply a “buy and hold” strategy when it comes to low price-earnings contrarian investing because this strategy eliminates all commissions, transaction costs and capital gains taxes.

Dreman states that an alternative would be to buy a portfolio of low price-earnings ratio stocks and periodically weed out stocks that reach the market price-earnings multiple or go above it, and stocks that fail to perform as well as the market over a certain period of time. Although this introduces trading costs, Dreman feels that the investor, on average, should only place a few trades per year.

Dreman’s methodology requires stocks to be sold when their price-earnings ratio approaches that of the overall market, regardless of how favorable the company’s prospects appear. When one holding is sold, it should be replaced with another low price-earnings stock.

An exception to that rule would be a stock that attains a high price-earnings multiple solely because of a decline in earnings. The low price-earnings approach will undoubtedly add several “clinkers,” as Dreman calls them, to your portfolio. Cyclical companies’ earnings move with economic cycles and when earnings have peaked, at the peak of an economic cycle, the price-earnings ratio will be lower (because of a larger denominator). When earnings begin to decline, the price-earnings multiple will be pushed upward, leading to a valuation that may be above the market price-earnings ratio. Dreman warns against selling cyclical holdings solely for this reason.

Overall, Dreman recommends a two-year holding period for stocks that have not worked out. He answers the question, “How long do you wait for a turnaround?” with two years, unless it is a cyclical company with a drop in earnings. In that case, an investor might wait two and a half to three years.

Following AAII’s Interpretation of the Dreman Screen

AAII tracks the Dreman screen in the Stock Screens area of the AAII website. A list of companies that pass the screen is updated each month. To receive a Stock Screens Update email that will alert you when new data is posted, go to www.aaii.com/
my-account/e-newsletters.

Subscribers to Stock Investor Pro can run the preprogrammed *Dreman Screen, save the results, and use the program’s research database to conduct further analysis on the passing companies.