What must it feel like to be famed contrarian investor who has had a great run and weathered numerous market upheavals, only to get booted for sticking to your guns?
David Dreman does not have to ponder on what emotions would erupt in such circumstances. He experienced it at the ripe age of 72.
In 2008, his funds, which were heavy on banks and financial stocks, plunged 35-45%. Dreman had chosen those stocks because they were cheaply valued and had low price-earnings ratios. He refused to sell them because he saw long-term value in them.
In the first half of 2009, DWS Investments, a retail unit of Deutsche Asset Management, fired Dreman as subadviser of its $2.9 billion DWS Dreman High Return Equity Fund. Consequently, it was renamed the DWS Strategic Value Fund.
He later admitted in various interviews that he did not realise how deeply the banks were invested in real estate and noted that the banks themselves did not realise it until it was too late. But Dreman was not in mourning. Institutional Investor reported in March 2011 that the $118 million large-cap Dreman Contrarian High Opportunity Fund, his firm’s equivalent of the DWS Strategic Value Fund, had gained almost 140% since the market lows of March 2009. By comparison, the S&P 500 climbed just over 100%, while the DWS fund was up roughly 115%. Dreman’s fund continued to hold many of those same financial stocks. “We knew we were dealing with survivors,” was his comment.
Dreman is a contrarian investor who looks for castaways in Wall Street’s dumpster. He seeks good companies that are temporarily out of favour where the market shows a major overreaction. Do note, the key term is “temporarily out of favour”, not companies that are in a deep turnaround that might not make it.
Dreman believes in studying the psychological underpinnings of the stock market and its impact on valuations. He believes that investors pay too much for companies that appear to have the best prospects at the moment and react too negatively to companies perceived to have the weakest prospects. They overvalue the “best” stocks which everyone is chasing and undervalue the “worst” ones which everyone is shirking. Emotions push prices from their intrinsic value. This is a self-correcting process that the veteran bargain hunter uses to his advantage.
There are plenty of examples that indicate he ruthlessly stuck to his philosophy no matter how the market was behaving.
Take British oil company BP. In Dreman’s view, investors overdiscounted the BP stock after 2010’s oil spill. Dreman Value Management's CIO Cliff Hoover told Morningstar that he believed that fundamentals trump hypotheticals. They did their own analysis and examined other spills through history, and came up with around $30 billion for future liability. They began picking up the stock in June 2010 despite the market assuming a $115 billion future liability for the oil giant.
That same year, Dreman set his sights on Ryanair when the stock price plunged in reaction to the volcanic eruption in Iceland which grounded many Ryanair flights. Hoover mentioned in an interview with ThinkAdvisor that the stock dropped from 20 times earnings to 12 times earnings. In no time they unloaded the stock after making a tidy sum.
A phenomenal long-term performer, he picked up Altria, the cigarette company, when it pummelled due to tobacco-related litigation. He grabbed Tyco International and held onto it when others were bolting in the midst of the scandal caused by accounting practices and business strategy. Post 9/11, he bought gambling stocks and saw them double within four months. Way back in 1982, Best Buy (a retailer), which had a 20%+ growth rate, announced it would have a couple of quarters that would be relatively flat. The stock price dropped though there was nothing wrong with the company. Dreman took positions in the $18 to $19 area and sold them in the high fifties around 18 months later.
Dreman has achieved a remarkable track record and an undisputed reputation as a value investor by learning from the very mistakes that threatened to ruin him. In the 1960s, he lost a considerable portion of his investments by chasing glamour stocks. When his net worth dropped by 75%, he worked on developing a core investment philosophy that he adhered to all his life, even when it was painful to stand out from the crowd.
His philosophy revolves around purchasing stocks he deemed to be low-priced using the price-earnings ratio, which measures how much investors are willing to pay for a company’s profit-making ability. He scouts for companies that are out of favour with the investing public, but boast of solid growth, strong fundamentals, and sound financials.
How David Dreman picks stocks
Dreman believes that markets are not perfectly efficient and that behavioural psychology plays a considerable role in stock price movements. The market overreacts to events and misjudges the prospects for stocks, often resulting in over-exuberance for outperforming stocks and outsized negativity for underperforming stocks.
Low price-to-earnings
He believes that the best way to identify these undervalued or out-of-favour stocks is through a low price-to-earnings (P/E) approach to stock valuation. Investors tend to put too much emphasis and, as a result, overvalue stocks that have strong earnings visibility. Whereas, low P/E stocks with a perceived weakness in visibility, are often ignored.
He rates companies on metrics like price-to-earnings (P/E), price-to-book or price-to-cash flow – all of which compare the share price with the underlying value of the business. A couple of years ago, in an interview with Barrons, Hoover explained it articulately by contrasting Exxon Mobil with Conoco when bringing out the point that there was money to be made then in energy stocks. “All the indexes and all the ETFs buy Exxon. Exxon has a 6% weighting in the Russell 1000 Value. But Exxon is selling at 13 times earnings and 10 times cash flow. You can buy Conoco at 5 times cash flow. You are not going to lose money in Exxon, but you are not going to make as much as you would by being more selective.”
When asked about his stock picks of banks and financial companies in 2008, he confessed to erring and wisely learnt from his mistake. He told the New York Times that buying stocks with low P/E ratios can make sense only if the earnings — the “E” — are real. “The E was much worse than anyone thought. The banks themselves had no idea of how bad the E was.” A point he reiterated in an interview with Forbes when he spoke of the “enormous leverage” and “complexities that do not show up in a balance sheet”. He stated that he would “probably never go as heavily as we had gone into financial stocks.”
High dividend yields
Dreman also looks for high dividend yields. As investors turn their backs and the share price falls, the dividend yield increases as a result. Value investors would naturally be interested. The yield helps to provide protection against a significant price drop, and also contributes to a return on the investment.
Earnings growth
Being devoted to low P/Es and high dividends as a means of producing superior performance is not a surefire way to latch onto a bargain. The two metrics only help investors identify stocks that are mispriced. What makes them attractive is the potential to grow. In an interview with the Wall Street Journal way back in 2002, he spoke about the folly of investors still holding on to battered technology stocks. “These companies' earnings aren't turning around. So if a stock drops 90% and still has no earnings growth or no earnings at all, what's it worth? We like companies with real earnings power.” His screening of stocks requires companies to deliver historical and future earnings growth that outperforms the S&P500.
Financial strength
To add to the downside protection of a shunned stock, Dreman also considers the financial strength of the company and looks for a low debt-to-equity ratio. A sound financial position will help the company absorb the pressures if it is going through some turmoil as well as provide a safety of measure for the dividend payout.
Size of the company
As a final precaution, he avoids the small companies and prefers to go with medium- and large-sized companies. For one, such companies are less likely to suffer terribly from operational or financial setbacks and they have a greater chance of a rebound. Next comes greater market visibility with the rebound – the higher profile companies gets more attention. Finally, there is a lower probability of “accounting gimmickry” due to the scrutiny placed on them by a wide range of investors and the regulators.
His sell discipline keeps an eye on when the stock’s valuation rises above the market or exceeds that of its industry; when a stock experiences a weak or declining price momentum; or deteriorating fundamentals.
He also admitted to Steve Forbes in an interview that it is wise to sell a stock if it shows a loss, no matter how short term and how crucial it is not to buy a stock if there is a loss. “I guess the most important would be the fact that if a company has a loss, even if we think it’s a short-term loss, we’ll sell it and buy it when the company comes back to profitability. That would have saved a lot of us in the financial crisis, because everybody thought those losses would have been very, very short-term, but they weren’t.” Another lesson learnt from 2008!
If you are keen to follow Dreman’s style of stock picking, then do pay heed to the advice he dispensed to investors during an interaction with Philip Durell for his newsletter Inside Value.
“The one thing to caution readers about is if you buy stocks, you are never going to get to the bottom. Unless you are very, very lucky. But even if you buy them 10-20% above the bottom and they double or triple for you, you are going to do very well. It is just a matter of once you have committed and you are confident, you have to have the patience to ride it out.”