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David Dreman and the art of contrarian stock-picking

Many of the world’s most successful investors have achieved great wealth and stellar reputations by learning from mistakes that have threatened to ruin them.

More often than not, the lessons of disastrous decisions have meant throwing away rulebooks, abandoning conventional wisdom and taking a very different approach to other investors. Very few have been more successful at doing that than celebrated Canadian investor David Dreman.

In the fourth article in this series, Ben Hobson, feature editor of guru investing strategy website Stockopedia, looks at how Dreman switched from chasing popular glamour to beaten down rogues – and made a fortune out of it.

Don't be distracted: David Dreman lost money on 1960s glamour stocks - after getting his fingers burnt he devised a system to hunt among shunned shares instead.

How one famous investor made a fortune by doing the opposite of everyone else

'Rule No.1: Never lose money. Rule No.2: Never forget Rule No.1.' There’s a delicious irony in Warren Buffet’s brilliant observation about the primary goal of a stock market investor.

Back in the 1930s Buffet’s future tutor and employer Benjamin Graham had to sell most of his possessions to cover his losses from the Great Crash. In the years that followed, Graham rewrote the rules on how to analyse shares, and Buffett later made a fortune by never departing from those principles.

  More... How to follow the investing legends and beat fund managers How to hunt for cheap shares: the secrets behind Benjamin Graham's bargains The formula to bargain shares? How Piotroski’s F-Score can help investors beat the market Share dealing: £12.50 flat fee and cheap dividend reinvesting Get a free Hargreaves Lansdowne guide to investing in an Isa

Come the late 1960s, another young City analyst was also losing money through his own investing mistakes. David Dreman, a Winnipeg-born researcher and investment officer was in his mid-30s when he lost most of his wealth by putting money into popular shares.

 

Ten years later he was running his own investment firm with a deep seated philosophy for acting against the popular consensus inDid this professor find t the market. It was the start of a move that brought him such respect that his firm at its peak managed $22bn in investments and made Dreman a very wealthy man.

Yet despite urging investors to recognise the behaviour of others and use it to their advantage, Dreman’s brand of so-called contrarian investing is still hard to swallow for many. Acting against the herd goes against basic human tendencies but if you can manage it, his experience shows that you can beat the market.

Dumping glamour and buying value Winning streak: Dreman turned his philosophy into a serious money-spinner. His firm once had $22bn in investments.

Like Ben Graham, the lesson that Dreman learned from being nearly wiped out by disastrous glamour shares was to look for value in the market.

He wanted out-of-favour shares in beaten down sectors where they could be snapped up for a song. All the time he was acting on the basis that most other investors were likely to be misjudging the market and that his stock picks would eventually be in the money.

To find these cheaply-priced value gems, Dreman employs a handful of simple measures taken to the extreme. He rates companies on common 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.

He also looks for high dividend yields, which can often be a signal that the market has fallen out of love with a share.

As investors turn their backs and the share price falls, the dividend yield increases as a result. For dividend investors this can be a warning signal – but for value investors it might warrant further investigation.

Dreman only looks at the cheapest 20 per cent of stocks in the market by each metric – the kind of shares shunned by the masses.

Given that the typical private investor underperforms the market by up to 6 per cent annually – while Dreman has consistently outperformed for his clients – his contrarian value approach is clearly a winning philosophy.

Indeed, research by his fund firm Dreman Value Management, tracked the largest 500 US companies between 1970 and 2010 and invested a theoretical US$1m in both the top 20 per cent and bottom 20 per cent of P/E stocks.

Updating the low P/E (cheap) portfolio annually would have produced a staggering compounded with-dividends return of $327m at the end of 2010. The return for the high P/E (expensive) group was just $26m!

To add some downside protection to his formula, Dreman also uses some fairly rigorous fundamental analysis to filter the wheat from the chaff amongst the bargain basement of the market. He generally avoids the smallest companies and looks for signs of earnings growth and financial strength as well.

He told the world his secrets, but still they ignored him!WHAT NEXT IN THE INVESTING GURUS SERIES?

Warren Buffett is one of the world’s wealthiest men and an inspiration to investors everywhere. But how does he do it? In our next article we’ll look at the investment philosophies have made the Sage of Omaha one of the most successful investors ever.

In his excellent book Contrarian Investment Strategies, Dreman set out a whole host of pointers for investors.

For the most part, he urged them to do away with the toolkit that most private investors use every day, namely ‘overly optimistic’ broker forecasts, technical analysis and any effort to ‘time’ the market.

Rather, he put far more store in being realistic about the potential downside of an investment, being patient and avoiding any highly priced share.

A typical Dreman-esque portfolio would have an investment pot equally divided between 20-30 of these value shares, filtered for robust financial strength, across 15 or so sectors.

Of course just knowing how to buy cheap stocks is rarely enough. Dreman uses some tough rules on the sell side to ensure he doesn’t fall in love with his shares. He sells whenever a P/E rises above the market or exceeds that of its industry. He’ll also sell whenever a share experiences weak or declining price momentum or deteriorating fundamentals.

Outperformance: Over 16 months since inception the Dreman model portfolio is up 60 per cent

How to be a contrarian and learn to love shares that nobody wants

Like many investing strategies that dig around for value shares, Dreman’s contrarian philosophy can prove difficult for an investor to live with.

From a psychological perspective, buying shares in potentially damaged goods is not an easy thing to do. Moreover, screening the entire market for cheap stocks with the right elements of quality can be very hard work.

 

Stockopedia’s four David Dreman inspired screens automatically scan the market for potential Dreman-eseque candidates using different valuation measures.

In surging markets, finding value shares is never easy but these screens do throw up some interesting ideas, particularly on the David Dreman High Dividend screen which has returned almost 58% since inception 16 months ago.

Among them are interdealer broker ICAP, price comparison website Moneysupermarket.com, oil and gas services company Petrofac and engineering group AMEC.

Occasionally, the screens produce potential candidates that are probably smaller than Dreman would have chosen. However, this was also a system designed for North America where there are many more stocks to choose from - so you’re likely to have to live with some compromises when implementing it in the UK.

Being a contrarian is worn like a badge of honour by those investors who recognise that sometimes the vast majority can be absolutely wrong about a share.

Going against the popular view in preference for value over glamour may seem unnatural but for those prepared to think differently, the lessons and fortune of David Dreman could prove handy inspiration.

About Stockopedia and the guru investing strategies

Our investing guru series is being written by Ed Page Croft and the team at Stockopedia. You can read This is Money's review of Stockopedia by Simon Lambert and more about the site at the links below.

But first a word of warning: The investing guru series seeks to explain the theories behind the great investors' success and highlight some shares that fit their methods.

We highlight the modelled returns their strategies could achieve based on actual stock market performance, however, never forget that past performance is not indicative of future returns.

It is also vital to consider that these and all other investment articles on This is Money are simply ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.   

Track the performance of all Stockopedia's GuruModel strategiesFollow @stockopedia or @edcroft on TwitterStockopedia free 2 week trial and £50 discount for This is Money readers

* No fee for publication is involved between This is Money and Stockopedia for this column.



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