David Dreman’s Blockbuster

David Dreman’s 1998 book Contrarian Investment Strategies: The Next Generation is a blockbuster.

Throw away everything that rests on the Efficient Market Hypothesis, Modern Portfolio Theory, the Capital Asset Pricing Model and Slice and Dice methods. David Dreman has proved convincingly that those theories are wrong.

For example, you may have been told that the return that you can get from an investment increases with risk, which is often described in terms of volatility. The opposite is true. Contrarian strategies (low Price/Earnings, low Price/Book Value, low Price/Cash Flow and high dividend yield) consistently outperform alternatives at a greatly reduced risk.

Here is an extremely important point from pages 382-383.

”On closer examination, the efficient market victory vanished. Studies we reviewed in chapter 14 demonstrated that the standard risk-adjustment tools the researchers used were too imprecise to detect even major fund outperformance of the averages. One showed, for example, that using Jensen’s technique (one of the important mutual fund investigators) only one manager of the 115 measured demonstrated superior performance as a 95% confidence level (the lowest statistical level normally acceptable).”

”Even to be flagged on the screen, the manager had to outperform the market by 5.83% annually for 14 years. When we remember a top manager might beat the market by 1.5% or 2% a year over this length of time, the returns required by Jensen to pick up managers outperforming the averages were impossibly high. Only a manager in the league of a Buffett or Templeton might make the grade. One fund outperformed the market by 2.2% a year for 20 years, but according to Jensen’s calculations, this superb performance was not statistically significant.”

I continue to be amazed how a failure to detect something is considered an adequate finding in economics and investment research. No other area of research allows for such conclusions. One must always identify what it takes for something to be detected. This is called the power of a statistical test.

Here are some rules for investors.

RULE 10. Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.
RULE 12. B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.
C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.
RULE 13. Favored stocks underperform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially. [Emphasis added.]
RULE 14. Buy solid companies currently out of favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

Supporting these rules is how humans react to information: the psychology of markets.

Here is an insight that is critically important in early retirement planning.

From page 169: “However, what works fine in financial theory often doesn’t consider investor psychology. Many investors, particularly the older generation, feel much more secure living on the dividends and keeping their capital intact. Sure they might have more capital in the end..which would require them to occasionally draw down on the principal for their living expenses. But their comfort level, as I have found, can often go down markedly. Following this strategy will not provide optimum returns, but it will outperform the market, before deducting dividends, and make a lot of people who depend on income sleep more soundly.”

How well do dividend-based strategies hold up? I will refer to Chapter 8.

These results are based upon the Compustat 1500, the 1500 largest stocks in the Compustat database. These correspond to what James O’Shaughnessy calls large capitalization stocks in What Works on Wall Street. Results are similar, but Dreman’s methodology is superior.

Dreman divided these stocks into quintiles (of 300 stocks each) according to their dividend yields. Even though the composition of each quintile changed from year to year, it did so much less than with O’Shaughnessy’s selection of only 50 stocks. The following results are for 1970-1996. There is sufficient evidence for us to accept his observations as representative. For example, O’Shaughnessy has presented a more detailed set of analysis tables [for slightly different conditions] that confirm these results.

The return (with dividends reinvested) for the quintile with the highest dividend yield was 16.1% with 8.2% coming from price appreciation and 8.0% coming from dividends [and 0.1% from rounding]. The return (with dividends reinvested) for the quintile with the second highest dividend yield was 17.5% with 12.1% coming from price appreciation and 5.4% coming from dividends. The market’s return (with dividends reinvested) was 14.9% with 10.9% coming from price appreciation and 4.0% coming from dividends. [Reference: Figure 8-4.]

In down markets during 1970-1996, the highest dividend stocks fell 3.8% (per quarter, averaged) in down quarters as compared to 7.5% for the market overall. [Reference: Figure 7-5.]

Here is Indicator 5.

“Indicator 5. An above-average dividend yield, which the company can sustain and increase.”

David Dreman: “In practice, I have found that indicator 5, an above-average and growing dividend yield, improved performance when used in conjunction with the primary rule of buying contrarian stocks.”

There is more. Much, much more.

David Dreman is very good about the practical aspects of investing, such as how long to hold a stock and keeping costs low.

What I like best, however, is his dedication.

“For Holly, Ditto and Meredith, without whose love, support--and pleasant diversions--this book might have been completed many months earlier.”

Have fun.

John Walter Russell
I wrote this on May13, 2005.