Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This week’s issue looks at the David Dreman-inspired Contrarian Investor strategy, which is up more than 25% this year and more than 40% in the past three months. Below is an excerpt from the newsletter along with several top-scoring stock ideas based on the Dreman investment strategy.

Taken from the July 24, 2009 issue of The Validea Hot List

Guru Spotlight: David Dreman

While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most — if not all — of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them — and their clients or shareholders — very happy.

But while most of the gurus upon which my strategies are based are contrarians, one stands out among all the others: David Dreman. Throughout his long career, Dreman has sifted through the market’s dregs in order to find hidden gems, and he has been very, very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper’s database.

Born in 1936, Dreman became interested in the stock market at quite an early age. His father was the chief trader at a large commodity firm in Winnipeg, Canada, and young David would often accompany his father to floor of the exchange as a youngster. According to Dreman Value Management’s website, while at the exchange he was able to observe first hand the dynamics of a very active market and the reaction of the traders and the markets in general.

After graduating from the University of Manitoba, Dreman first worked as a security analyst at his father”s trading firm in Winnipeg. By 1977, he had opened his own firm, and soon he was posting impressive results by focusing on stocks that were overlooked, “beaten up,” or sometimes in the midst of an outright crisis. Throughout his career, he did the same thing, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).

Psychology Matters

How — and why — did Dreman manage to pick winners from groups of stocks that few other investors would touch? The answer may at least in part go back to young Dreman’s days on his father’s trading floor, when he got to see how the market moved, and, more importantly, how the traders responded to it.

Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the “best” stocks — those “hot” stocks everyone seems to be buying — and undervalue the “worst” stocks — those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to “surprises”, frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.

When you put those factors together, you get the crux of Dreman’s contrarian philosophy. Because the “best” stocks are often overvalued, good surprises can’t increase their values that much more. Bad surprises, however, can have a very negative impact on them. The “worst” stocks, meanwhile, are so undervalued that they don’t have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a “contrarian” approach — i.e. targeting out-of-favor stocks and avoiding in-favor stocks — Dreman found you could make a killing.

Focus on Fundamentals

Specifically, Dreman compared a stock’s price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock’s price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20 percent of the market, it was a sign that investors weren’t paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20 percent of the market in at least two of those four categories to earn “contrarian” status.)

But Dreman also realized that just because a stock was overlooked, it wasn’t necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock’s ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock’s industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.

Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. “A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest,” he wrote in Contrarian Investment Strategies. “People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new.” Dreman’s advice: “Buy during a panic, don’t sell.”

The Picks

As you might imagine, my Dreman-based 10-stock portfolio — which includes the top stocks picked by my Dreman strategy — will tread into areas of the market others ignore because of its contrarian bent. Its current holdings, for example, include two financials, some telecoms, a utility, and a healthcare company, all of which involve areas that have been lagging in recent months (except for financials, which still have a significant cloud of fear hanging over them). Here’s the full list of the portfolio’s holdings:

Since its inception, the Dreman-based model has been a strong performer, but it’s been a rocky road at times. The portfolio was one of my best from 2003 through 2006, at least doubling the S&P 500’s gains in each of those years. But when value stocks went out of favor in 2007, so did the Dreman model. It lost 12% that year and was hit quite hard in last year’s crisis, losing another 54.8%.

But then, just as Dreman has done in his career, the portfolio took advantage of others’ fears. It snatched up a lot of bargains that others had discarded, and is up 25.4% this year (including 41.7% in the past three months), putting it up 40.3% since its inception more than six years ago. That’s an annualized gain of 5.8%, in a period in which the S&P 500 has fallen 0.4% per year. The Dreman model has also been my most accurate approach, making gains on more than 60% of its picks over the long haul.