David Dreman made his name and fortune by going against the crowd. As one of the pioneers of contrarian investing, he built an impressive track record by systematically targeting stocks that were out of favor with the market. Let’s explore how Dreman developed his contrarian approach and break down the key elements of his quantitative strategy.
The Psychology Behind Contrarian Investing
At the core of Dreman’s philosophy is his deep understanding of investor psychology. He recognized that investors tend to overreact systematically and predictably – overvaluing “hot” stocks and drastically undervaluing those that have fallen out of favor. This consistent behavioral pattern creates opportunities for investors willing to go against prevailing market sentiment.
Dreman found that when negative surprises hit popular stocks, they had much further to fall. Conversely, beaten-down stocks had limited downside and significant upside potential when positive news emerged. By focusing on unloved but fundamentally sound companies, Dreman aimed to capitalize on these asymmetric reactions.
Defining a Contrarian Stock
How exactly did Dreman identify contrarian opportunities? He focused on four key valuation metrics, looking for stocks in the bottom 20% of the market on at least two of these measures:
- Price-to-earnings (P/E) ratio
- Price-to-cash flow (P/CF) ratio
- Price-to-book value (P/B) ratio
- Price-to-dividend (P/D) ratio
His research showed that stocks ranking poorly on these metrics consistently outperformed the market and their more popular counterparts. For example, stocks in the bottom 20% of P/E ratios delivered 19% annual returns versus 15.1% for the market between 1970-1996.
Beyond Cheap: Quality Matters
While valuation was crucial, Dreman wasn’t interested in just any cheap stock. He wanted financially sound companies that were temporarily out of favor, not those facing fundamental business problems. To identify quality contrarian picks, he looked for:
Size and Financial Strength
- Market cap among the largest 1,500 stocks
- Current ratio above 2 or higher than industry average
- Debt-to-equity ratio below 20%
- Return on equity in the top third of large caps
Earnings Power
- Rising quarterly earnings trend
- EPS growth exceeding the S&P 500 (for non-cyclical companies)
- Pretax profit margins of at least 8%
- Payout ratio below historical average
A Different View on Risk
Notably, Dreman rejected the conventional wisdom that equated volatility with risk. Instead, he viewed risk as the probability of not meeting long-term investment goals. He considered inflation the biggest threat to investment success, not short-term price swings.
This perspective led him to favor stocks over bonds, particularly during market crises. His research showed that after major market panics, stocks rebounded strongly, gaining an average of 25.8% one year later and 37.5% within two years.
The Strategy in Practice
Our testing of Dreman’s approach demonstrates its effectiveness. A 10-stock portfolio based on his criteria returned 79.2% over five years from 2003-2008, nearly quadrupling the S&P 500’s gain. The strategy showed particular strength in 2003, 2004, and 2006, with returns exceeding 30% in each of those years.
Importantly, these strong returns came with relatively low volatility. The portfolio maintained a beta of roughly 1.0, meaning it was no more volatile than the broader market. This aligns with Dreman’s view that contrarian value investing, while sometimes requiring patience, need not be especially risky.
Key Success Factors
Several aspects of Dreman’s approach appear crucial to its success:
Systematic Screening By using clear quantitative criteria, the strategy removes emotion from the investment process. This helps investors stick to their guns even when sentiment turns strongly negative.
Focus on Quality The emphasis on financial strength helps avoid “value traps” – stocks that are cheap for good reason. This distinguishes Dreman’s approach from simple deep value investing.
Industry-Wide Application Dreman would often target entire out-of-favor sectors, not just individual stocks. This provided diversification while still maintaining exposure to potential turnaround situations.
Long-Term Orientation The strategy typically requires holding periods of 2-3 years (and sometimes up to 8 years) to realize full value. This patience is essential for contrarian success.
Implementation Challenges
While Dreman’s strategy is clearly defined, implementing it successfully requires:
- Emotional discipline to buy unpopular stocks
- Patience to hold through periods of underperformance
- Sufficient diversification across sectors
- Regular rebalancing as valuations normalize
- Careful monitoring of fundamental quality metrics
Conclusion
David Dreman’s contrarian strategy offers a systematic approach to profiting from market overreactions. By combining strict value criteria with quality filters, it helps investors identify promising turnaround candidates while avoiding permanent capital loss.
The strategy’s strong historical performance and relatively low volatility make it worth considering for value-oriented investors. However, success requires both strict adherence to the quantitative criteria and the temperament to stay the course when sentiment turns negative.
In today’s market environment, with increasing volatility and rapid sentiment shifts, Dreman’s disciplined contrarian approach may be more relevant than ever. His emphasis on fundamental value and market psychology provides a valuable framework for navigating market extremes.
Further Research
