The Dean Of Contrarian Investing

Foreword from ShareInvestor

This article “The Dean Of Contrarian Investing” by Samantha Lee was first published in The Business Times on 23 Jul 2007 and is reproduced in this blog in its entirety.

David Dreman has accumulated a resume that can only be described as superlative. Samantha Lee finds out more about the noted investor

David Dreman’s slender build and genial grin belie his reputation as one of the time-hardened pioneers of contrarian investing. Known widely as the “dean” of contrarian investing, Mr Dreman wrote the book-literally-on the subject.

Born in 1936 in Manitoba, Canada, Mr Dreman graduated from the University of Manitoba in 1958. He started off his financial career as an analyst in his father’s Canada-based commodities trading firm, but the allure of Wall Street was difficult to resist. Mr Dreman moved stateside where he founded his highly successful investment firm – Dreman Value Management Inc – in 1977.

He has never looked back since. Mr Dreman has accumulated a resume that can only be described as superlative. His successor firm Dreman Value Management LLC, of which he is the founder, chairman and chief investment officer, boasts a large-cap value composite that beats the Standard & Poor 500 index by an average of 3.9 percentage points over the last 10 years.

His firm’s small-cap value composite also bested the Russell 2000 by 6.6 percentage points over the same period.

His achievements, however, extend far beyond the realm of Wall Street, Mr Dreman has authored several acclaimed books on contrarian investment strategy. His first bestseller, Contrarian Investment Strategy: The Psychology of Stock Market Success (1980), has procured a permanent position in the annals of finance literature.

Mr Dreman has also been a regular columnist for Forbes magazine for more than 20 years, while occasionally writing articles for the Journal of Investing, Financial Analyst’s Journal and the Journal of Financial Behaviour. Dr Dreman’s contrarian philosophy is not for the faint-hearted. His strategy requires one to go against his gut instinct, to avoid making decisions solely based on emotion. He recommends that purchasing low-cost stocks that the market and the public hate will lead to great results.

With this paradoxical view in mind, we shall now investigate Mr Dreman’s investment strategies that have served him so well over the past three decades.

The Non-Conformist

As its name suggests, the contrarian philosophy is distinguished by its unconventional approach to investing. A contrarian investor eschews public consensus and buys or sells particular stocks when others are doing the exact opposite.

The rationale behind this is that the “herd mentality” among investors may lead to inaccurate pricings in securities markets, which the contrarian investors can exploit to their advantage.

Mr Dreman was once part of the herd. As a green investor in 1969, he invested in the hottest stocks of the day and watched in disbelief as the shares of small companies with negligible profits soared into the financial stratosphere. “I invested in the stocks du jour and lost 75 per cent of my net worth.” he once said in an interview with SmartMoney Magazine.

That was the turning point in Mr Dreman’s career. He has since become well-known for his unusual choices in investments. Richard Zeckhauser, a behavioural finance course instructor at Harvard University, reportedly summed up Mr Dreman’s investing attitude this way: “If he were to choose between a BMW and a Buick, he might want the Buick. He will not overpay for the status.”

Indeed, Mr Dreman has invested in, and held on to, stocks in Big Pharma companies such as Johnson & Johnson, Merck and Pfizer, companies well-known for being plagued by lawsuits on a regular basis.

The Psychologist

Dreman’s contrarian philosophy is deeply rooted in human psychology. “Psychology is probably the most important factor in the market,” he was quoted as saying in a Forbes magazine article. “And one that is least understood.”

His company, Dreman Value Management LLC, has thus pioneered groundbreaking research in behavioural finance.

After his huge losses in 1969, Mr Dreman turned his back on the crowd and nursed his wounds by studying the effect human psychology has on investment decisions.

He is particularly fascinated with the way people make investments based on irrational, emotional decisions instead of cold hard logic.

For example, even though many investors lose money from forking out for overvalued stocks, they repeat the mistake over and over again.

“Why don’t people just get it?” Mr Dreman once asked in a SmartMoney interview. “We know from 50 years of data that low price-to-earnings stocks will outperform high price-to-earning stocks.”

He observes that US$1 million invested in low-P/E stocks since the 1970s would have earned US$228 million, as opposed to US$23 million from those with a higher-P/E ratio.

The Bargain Hunter

Armed with his wealth of knowledge in behavioural finance, Mr Dreman practises what he preaches. He has been known for possessing an uncanny ability to identify bargain stocks and to stick by these securities until the market stops pummeling them.

For example, in 2002 he audaciously invested in Bermuda-based conglomerate Tyco international amid the embezzlement scandal involving CEO Dennis Kozlowski. He explained his predilection towards discount stocks in an interview for Kiplinger’s Personal Finance Magazine: “I buy stocks when they are battered. I am strict with my discipline. 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 long periods of time.”

He typically invests in large companies with solid foundations that have, for some reason or other, invoked the ire or escaped the notice of the public. These can be identified by their low P/E ratio, cash flow, book value or dividends.

In short, he exploits public fear to his advantage and buys unpopular stocks at discount prices.

However, contrarian investing may not be suitable for the timorous. A staunch belief in one’s decision is essential when one goes against overwhelming public opinion.

Take Dr Dreman’s investment in cigarette company, Altria. Even though it has been afflicted in recent years by tobacco-related litigation, it has proved to be a great profit maker in the long run.

He maintains that “if you have good stocks and you really know them, you’ll make money if you’re patient over three years or more”.

In order to succeed in contrarian investing, one therefore needs to possess patience, a rational mindset and a good dollop of audacity.

After all, Mr Dreman’s favourite quote from banker Lord Rothschild displays his ruthless attitude towards investments: “The best time to buy is when there’s blood on the streets.”