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I was recently re-reading one of my favorite investment books by David Dreman, Contrarian Investment Strategies – The Next Generation.
David Dreman is the founder and Chairman of Dreman Value Management. He’s published many scholarly articles and has written four books. Dreman also writes a column for Forbes magazine and he’s on the board of directors of the Institute of Behavioral Finance, publisher of the Journal of Behavioral Finance.
Over the past 30 years, Dreman has been at the forefront of research into contrarian value investing and behavioral finance, proving that over virtually every time period measured, stocks which were out of favor, as reflected by their price/earnings multiple, did significantly better than stocks considered to have more favorable outlooks.
While I was reading through this classic investment book, I came across this piece covering, “If contrarian strategies do so well, why doesn’t everyone use them?”.
Buy solid companies currently out of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.
You might wonder: If these strategies do so well, why doesn’t everyone use them?
This lands us smack in the realm of investor psychology (or Behavioral Finance, as it is now called by economists). Though the statistics drag us toward the value camp, our emotions just as surely tug us the other way. People are captivated by exciting new concepts.
The lure of hitting a home run on a hot néw idea overwhelms caution. The sizzle and glitz of an initial public offering like a Planet Hollywood at 140 times earnings and 13 times revenues, or a Spyglass, an Internet search engine designer priced at 175 times estimated earnings, is just too great.
While these are extreme examples of investor evaluation run amok, they show why value strategies have worked so well over the years. People pay for concept, whether in the absurd cases of Planet Hollywood or Spyglass, or in consistently overpricing the trendy industries of the day.
Investors just as surely want to stay well away from companies whose outlooks seem poor. Most investors have a negative reaction to contrarian stocks. Recall that these companies violate just about every idea of proper investment theory. “Do you know what’s down there?” a major money manager once asked me, shaking his head in disapproval, “How can any prudent man look at companies like these with such unthinkably poor visibility?”
The favored stocks, on the other hand, present the best visibility money can buy. How then can one recommend such a reversal of course?
The psychological consistency of the error is remarkable. There are of course, excellent stocks that justify their price-to-earnings ratios, and others that deserve the slimmest of multiples. But, as the evidence indicates, these are relatively few, and the chances of recognizing them are very small.
Contrarian strategies succeed because investors do not know their limitations as forecasters. As long as investors believe they can pinpoint the future of favored and out of favor stocks, you should be able to make good returns on contrarian strategies. Human nature being what it is, this edge should continue for a few years longer.
We have seen how consistently contrarian strategies have worked for investors over the years. The good news for you is that this wave of discoveries provides strong evidence that there are consistent high-odds ways to beat the market.
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