Popularly known as the "Guru of Contrarian Investing", David Dreman follows an investment philosophy based on low P/E approach to stock selection. Dreman, who has authored the recent Contrarian Investment Strategies: The Next Generation, among several other investment books, is also the Founder and Chairman of Dreman Value Management. His Large Cap Value Fund has returned on an average 17 per cent annually, and Small Cap Value Fund 16.5 per cent annually, since inception in 1991.
There is a bit of difference between value investing and contrarian investing. Basically, I buy stocks when they are really battered. I am very strict with my discipline. I always buy stocks with low price-earnings ratios, low price-to-book-value ratios, low price-to-cash-flow ratios and higher-than-average yield.
Academic studies have shown that a strategy of buying out-of-favour stocks with low P/E, price-to-book and price-to-cash-flow ratios outperforms the market pretty consistently over very long periods of time. The operative phrase there is `very long periods of time'.
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Psychology is probably the most important factor in the market — and the one that is least understood. There's constant overreaction in the market. Low-P/E stocks are constantly priced too cheaply over long periods of time, and higher-P/E stocks are priced too dearly. People like exciting stories; they don't like boring companies. That is the normal cause of investor overreactionAlthough financial advisers uniformly praise good long-term records, most concentrate on performance over short terms, like three years.
The problem is that this period may be shorter than the life span of a Wall Street fad, like Internet stocks. First-rate funds may look weak over three years, as many did during the tech bubble, because their investing styles are temporarily out of favour.
Anyone can get lucky for three years. Daniel Kahneman of Princeton won the Nobel Prize in economics for, among other things, showing that this fixation with sizzling near-term performance hurts investors. Avoid the problem by looking at 10- or 15-year numbers.
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If you follow them (popular trends), odds are you're buying near the peak, and the lovely outperformance will end soon. Today hedge funds are hot, driven by billions of dollars that advisers are shepherding into this sector. The same is true for foreign securities, gold and natural resources. Am I being too hard on financial advisers? If the news is better than expected, the Dow Jones industrial average shoots up 150 points; if worse, the drop is just as steep.
Hedge fund managers, day traders and swarms of other quick-buck types trade instantly to get the edge from news flashes. Maybe you can make money trading on these moves, but only if your transaction costs are nil and your computer is ten seconds faster than every other trader's. Neither condition holds.