David Dreman: Why the Low PE Approach Works

Johnny HopkinsDavid DremanLeave a Comment

One of my favorite investors is David Dreman.

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.

One of my favorite Dreman interviews was one he did at GuruFocus where he discusses his investment strategy using the low PE approach. It’s a must read for all value investors.

Following is an excerpt from the interview:

The low PE approach has become a cornerstone of your investment strategy, but we’ve also heard other investors say they avoid relying too much on just the PE ratio. Are there other measures that you also look at?

(Economist) Eugene Fama’s colleague Kenneth French has looked at low PE since the 1950s or ’60s, and it outperformed the market and the S&P every decade since then. Our firm is also finding we’ve always had somewhat better results with low PE portfolios, or low price-to-book portfolios. But low price-to-book, low price-to-cash flow and low PE have always outperformed the market enormously over 10, 15 and 20 years.

For example, we did a 35-year study where if an institutional investor had $1 million, he’d have about $250 million at the end of those 35 years. This is against half of that for the S&P and much less for higher PE stocks. However, this doesn’t often work over any one- or two-year period. In the late ’90s during the Internet bubble, low PE was just knocked out. It was a bad time for all of us. I remember wondering in 2000 how much longer we could have our clients as unhappy as they were.

Many value firms bought low PE at the very end, right at the top, and for the first three months of 2000, it was the same. We were just getting battered. And then in nine months it changed entirely; we were actually up 51% or 52% that year, and the market was down 10%. I wondered how many years it would take to get back, and it did it in nine months.

Is it more important to compare the PE of a company to the rest of its industry or mainly against its own history?

We tend to just take the absolute lowest PEs and most of the studies have been done this way. In the early ’60s, there were quite a number of papers written on low PE, but the efficient market theory was started to expand and catch on. The low PE papers said it was risky, or that there were methodological flaws. Professor Fama loves that word, that there’s always a methodological flaw. I guess what I got into doing in the late ’70s was I took all of the methodological flaws out, and we still outperformed the market.

One question that a reader has asked is what are the important metrics in evaluating a bank or an insurance company?

They’re very difficult companies to evaluate. If we look at the 2007 to 2008 financial crisis, banks were in trouble. And you couldn’t really see it by looking at their statements. You’re almost flying blind, especially in a bubble. It’s difficult to evaluate a bank or insurance company because too much is hidden. I would say as a rule to stick with the bigger ones. Stick with those that work most of the time, are fast growing or are mid-level banks. When a bank or insurance company starts to lose money, you won’t be able to find the spot, so the best thing is to get out.

One of the reasons why you’ll let go of a holding is because of deteriorating fundamentals. Can you elaborate on your sell philosophy?

We have a rule that if after three years, if the company hasn’t gone up, has not kept up with the market or is well behind the market, you don’t hold on. There was a follower of Benjamin Graham who I knew years ago, and he was doing exactly what Ben Graham did. He bought stocks and just held them forever because they were cheap. But what happened is many of them got cheaper.

We’ve always had a holding period depending on how cyclical a company is — about two to three years. If a company is good, it should work out within two and a half years. And if it doesn’t work out by three years, we’ll sell it and come back another time. But not a few times have we sold, and within six months, it was taken over by good companies. There’s no hard and fast rule, but it’s a good rule to keep your portfolio fresh and prevent locking yourself in. Ben Graham bought a lot of tech stocks because they were cheap, but they never went up.

Do you meet with management before investing?

Sometimes, yes, but we’ve found that a good manager can charm the analyst and talk about points that are not really there, or are not as strong as they seem to be. We talk to management and we want to know their plans, and we’ll watch them. But we look more at what they’ve actually done, and what they say they’re going to do.

When you do meet with management, what qualities are you looking for?

We want to see a manager who knows the company and products well and has very interesting ideas about how to expand the product line. They should have a strong approach to expanding or improving the firm, not just defending what’s there. You have to have real substance to what you’re doing. If I have more than 10 pages in the financial notes, then I don’t want to be near that company, because you wonder if there’s a lot more hidden.

Is there any advantage to investing with smaller or regional banks over national ones?

There are some national banks that I like and others that I don’t like. I’ve never been much of a believer in Citibank (NYSE:C) or Bank of America (NYSE:BAC) because they’ve always had problems. The government bailed both of them out, and they still have problems. On the other side, you have Wells Fargo (NYSE:WFC) or PNC (NYSE:PNC), or even JPMorgan (NYSE:JPM); these companies are on the whole more conservative. They went from being a lender on a large scale to building a good bank branch network. Wells Fargo doesn’t take the risk like JPMorgan on options and things of that sort. But it’s built very solid banking and mortgage lending businesses.

In your recent Forbes column, you mentioned a few positives about investing with American banks. Are there any foreign banks where you’re seeing opportunities, or should investors stick with U.S. banks?

At this point in time, I think the U.S. banks are very solid. They’ve overcome the mortgage crisis, and they had enormous help from the Federal Reserve. The lower interest rates, of course, are not helping them. They’re not helping any banks. Considering the solidity of the banks — the fact that they’re carrying much more capital, 10% capital now — they’ve changed entirely since the financial crisis.

When I look at the French or Italian banks, I’m a little more worried about the fact that these countries aren’t prospering all that much, and Greece, obviously, is prospering even less so. They’re spending an awful lot of money, and GDP is still scarcely growing in Europe. At some point I’m worried about the major inflation in Europe, and possibly some inflation here, but not to the same extent as Europe. On the whole, I favor American banks or good Canadian banks. Canadian banks never got into the financial crisis; the Canadian government didn’t allow a mortgage to go out without 25% down.

Could you tell us about an investment mistake that you’ve made and what you learned from that experience?

There are too many that we all make. Warren Buffett (Trades, Portfolio) said if you get six out of 10 right, you’re going to make a lot of money. A mistake we’ve made in the past is holding bad stocks for too long because we didn’t have good information about the depth of the losses. The mistake is sometimes with the oil markets; it’s pretty clear that the oil stocks were in an oversupply situation for about a year. We paid some attention but not enough. We got out of some oil stocks, but we were still burned a bit. If an industry is starting to change and all the indicators are blowing that way, it’s best to start to cut back. We’re always looking for these bubbles.

For example, Facebook (NASDAQ:FB) is doing extremely well right now, but some other tech stocks are not doing nearly as well. They had a very high price. There are established leaders in the area like Google (NASDAQ:GOOGL), Facebook and Apple (NASDAQ:AAPL), and they’re definitely likely to continue to grow but not at the rates that they have. Those companies are still attractive, and what the low PE discipline does is keep you away from the bubbles.

It’s similar to the argument for not following the bottom-up approach too closely; you have to look at what’s going on in the industry and the sector as a whole.

Sometimes it’s marketwide, and the approach avoids paying too much for stocks. During that internet bubble back in the late ’90s, I did a cash flow analysis of AOL, and I found out that in order to justify its PE at the time, it would have to have something like 15 billion subscribers. There are only about 7 billion people on the Earth, so that’s a bit of a stretch.

Are there any specific industries or sectors right now where you’re seeing some bargains?

As this market goes down, there are some industries that are getting more and more interesting. The banking industry is still getting clobbered, and although the American banks are likely to come back — they’re increasing their dividends over time, the cash flow is strong — what they need is somewhat higher interest rates. Banks look good to me and some of the other financial areas seem reasonable.

Also, at some point, the oil stocks will be more interesting again. They’re getting chopped apart right now, and it’s probably much too early. Given ISIS’ proximity to Saudi Arabia, and the overall tension in Middle Eastern countries, you don’t know what will happen there.

What books would you recommend to a beginning investor?

One of the classics is “The Intelligent Investor” by Benjamin Graham. Also, one of my books, “Contrarian Investment Strategies: The Psychological Edge.” I try to find books that have a solid pathway to making money over time. The average money manager is behind the market 90% of the time. I should probably keep this to myself, but I prefer the ETFs over, say, a mutual fund because the mutual fund charges are so high. For the average investor, I would say the best thing to do is go into an index fund.

I’ll read investing books by some of the major investors just to see what they’re doing. A good book is “Liar’s Poker” by Michael Lewis. He’s not an investor, but he gives a good overview of market crashes. I would also recommend reading — and this is an old book — “Extraordinary Popular Delusions & the Madness of Crowds” by Charles MacKay, written in the mid-19th century. Nobody describes bubbles as well.

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