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How to Invest Like a Contrarian

The value-stock guru David Dreman talks about his new book, lessons learned, and what he sees in today's market.

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If you're the kind of investor who believes in the wisdom of crowds, David Dreman has a thing or two he'd like to say to you. Since the 1970s, Dreman, chairman and managing director of Dreman Value Management, has been championing a value-oriented investing philosophy that favors stocks with low P/E ratios. In his newly released Contrarian Investment Strategies: The Psychological Edge, an update of his 1998 best-seller Contrarian Investment Strategies: The Next Generation, Dreman explains the psychological principles underlying his approach and how emotions can lead investors astray. He shared his insights on the past, present, and future with Morningstar.com.

In your book you write that both professional and amateur investors are subject to strongly held feelings and emotions that skew their perceptions of probability. Is there any way to help investors control these impulses, or are they an inescapable part of human nature?
The impulses are very powerful on all classes of investors, and because they are emotional, they recur repeatedly. Because of these emotional forces, investors often cannot learn from the past. However, the book provides several dozen rules that, if followed, will prevent readers from making most of the costlier mistakes that are so common in the marketplace. The answers often appear to be easy to understand. But carrying them out is far more difficult because of the emotional forces I described in the text. 

One of our most important rules is to buy stocks that trade at below-market P/E multiples. Academic studies, and our own, ranging over 65 years show that low P/Es and other contrarian strategies have consistently outperformed the market over time. A second important rule is not to rely on finely tuned earnings estimates. Although most analysts believe that if earnings come in even 3% under estimates, a stock can fall sharply, the average consensus miss since the early 1970s has been closer to 50%.

Your book is highly critical of the efficient-market hypothesis, saying the theory is flawed because it assumes rational behavior on the part of investors. But don't criticisms of EMH, valid though they may be, overlook the value of indexing as a cost-efficient, tax-efficient strategy for many small investors?
The question is a good one. Studies going back decades show that only about 10% of money managers outperform the market in any 10-year period. So indexing is a good course for most investors to take. Indexing was recommended by EMH advocates because of the belief that sophisticated investors keep market prices where they should be. In effect, we recommend indexing for precisely the opposite reason. Far too many money managers underperform the market because of the psychological barriers noted above.

You mention P/E, price/book value, and price/cash flow ratios as well as high yield as key metrics in determining whether a stock is overpriced or underpriced. Does gut instinct play any role in your decision-making process? How can you avoid so-called value traps, or companies that are cheap for good reason?
Unfortunately, gut instinct is the graveyard of all too many portfolios. Contrarian strategies, by contrast, are based on very strong statistical probabilities, that investors constantly repeat the psychological mistakes they make over time. As the book lays out in detail, we can build portfolios based on these mistakes. We now have strong results going back more than 70 years that show the superior performance of these strategies.

We have a number of rules to avoid value traps. Among the most important are to not buy companies that are reporting losses and to have a large number of stocks in a portfolio that is equally weighted, to take the sting out of a devastating earnings surprise or other setback for any one company. I recommend equal-weighting of a large portfolio--at least 100 stocks and possibly more. Such portfolios over time have significantly outperformed the market.

How do you know when it's time to sell a contrarian stock? Once it's fairly priced? Overpriced?
You never really know when to sell. We buy stocks that are significantly below the market as measured by low P/E, low price/book value, or low price/cash flow ratios and sell them when they reach the market multiple. At that time, we buy other cheap value stocks. Although this system is not perfect, it has worked very well over time.

Your book takes a look at several historical examples of bubbles and manias. Do you see any bubbles in the market today? In bonds, perhaps?
Yes, I think the bond market, particularly long Treasuries, are a major bubble that will hurt a lot of people before it's over. Ten-year Treasuries are yielding about 2%, while 30-year Treasuries are at 3%. Adjusting for inflation and taxes, this has almost never happened before. In the rush to Treasuries after the market collapse and financial crisis of 2008, people's only thought was to preserve their capital. What they overlook today is that the economy is slowly coming back and the S&P 500 has more than doubled from its low. The Federal Reserve and budget deficits together have almost doubled our national debt since 2008. As unemployment gradually goes down, we are likely to see higher inflation because of the vast amounts of money printed in this country and abroad. A 1% rise in the yield of a 30-year bond takes principal down more than 15%. If inflation does move higher, Treasuries, one of the best performers of the past decade, are likely to be one if the worst in the next, while stocks, which as a group have been mediocre performers at best, are likely to flourish in this environment. 

After years of underperformance, financials have shown signs of life lately and would seem to fit many of your criteria as a good area for a contrarian investment. What's your take on where financials stand today? On a related topic, how do you feel about European stocks?  

Financial-services companies are slowly rebuilding their capital and cutting down on their subprime exposure. There are still a number of lawsuits ahead and possibly some further governmental road blocks to handle, but the situation for financials stocks is improving. The Federal Reserve is also making an effort to buy more subprime securities, while the current administration is studying how to keep people in their homes with lower payments for some years. All of this is eating into housing oversupply. Whether it is a year or two longer, the great housing bubble will gradually dissipate, which will free bank balance sheets significantly and, in the process, increase their profitability and dividends substantially. Although insurance companies and other financials face somewhat different situations, the common denominator is that rising housing prices will help virtually all financial industries.

The European crisis should play an increasingly lesser role on markets as time goes on. For the moment at least, Greece has not Humpty Dumptied. If it does, I think that Germany will find a diplomatic solution to have them play a lesser or no role in the EU. In the meantime, with investors taking losses of well more than 50% on Greek bonds, more and more of them, along with some banks, are going to ask why buy Greek bonds at all. Good European stocks have done much better than Greek or Portuguese bonds or bonds of other weaker European nations. This should result in European stocks rising far higher over time than euro bonds.

Looking back on your more than three decades as a contrarian investor, is there one particular investment that stands out as your finest moment? What about a biggest mistake?
One of my finest moments was staying away from buying Internet stocks in the late 1990s, when everyone, including many value managers, were loading up on them at obscene prices. This proved very costly for awhile as the book describes, but by all the rules of fundamental analysis, which in those years were almost entirely abandoned, stocks were in what proved to be the largest bubble both in size and in investor participation in history. It was rough-going for several years, particularly because many of my value colleagues gave up and went with the flow. But when the bubble broke in 2000, our since-discontinued DWS Dreman High Return fund was up 43% that year, while the S&P 500 was down 10%. Not only was our performance record that we thought would take years to rebuild made up in nine months, but we also outperformed the market by another 15% since the bubble's inception.

The worst mistake we made was relying far too much on bank statements by their most senior officers and their balance sheets, which told us almost nothing during the 2007-08 financial crisis. We knew that there was serious subprime overbuying by the financial institutions. But it was impossible to know the enormous amount from either the information published or by talking with the senior management teams.

What only came out much later with the Levin Commission and other Senate and congressional investigations was just how overleveraged most of the big banks, investment bankers, and hedge funds actually were. At the time, all denied it, and only the insiders such as  Goldman Sachs Group (GS),  Morgan Stanley (MS), and a small number of other banks and hedge funds knew the entire story, including just how widespread the practice of selling credit default swaps and other exotic derivatives had been to their financial profitability, while most financial institutions floundered or went down for the third time buying them.   

The one good part that came out of this fiasco for our company was the belief that stocks were wildly undervalued by the spring of 2009, and we bought the unloved and unwanted exploration-and-development companies, mines, major manufacturers, and strong financials stocks at a fraction of their real value. We continue to hold the stronger companies to this writing.

Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.