Every other issue of The Validea Hot List newsletter examines in detail one of John Reese’s computerized Guru Strategies. This latest issue looks at the David Dreman-inspired contrarian strategy, which has averaged returns of more than 8% per year since its inception more than six years ago. Below is an excerpt from today’s newsletter, along with several top-scoring stock ideas based on the Dreman investment strategy.

Taken from the April 30, 2010 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.

Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, 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).

How — and why — did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, 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. Surprises happen often, and 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.

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% 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% 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.”

This type of contrarian approach isn’t for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they’ve been overlooking. And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market. The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.

But, as fears abated and the crisis passed, investors began to recognize the strong stocks they’d been shunning. And the Dreman portfolio has reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and another 10% or so thus far this year (vs. about 6% for the S&P), putting it well ahead of the broader market for the long haul. The Dreman portfolio has now returned about 70% (more than 8% annualized) since its July 2003 inception, compared to about 18% (or 2.5% annualized) for the S&P 500.

As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Its current holdings, for example, include several picks from some of the most maligned sectors — four from the financial sector (which is still the subject of much investor skepticism); three from healthcare (which many have shied away from because of fears about the new healthcare bill’s impact); and even one from the airline industry, which has had its fair share of problems in recent years, including the impact of the Iceland volcano’s eruption.

Here’s the full list of the portfolio’s holdings:

Bristol Myers Squibb Co. (BMY)
Southern Copper Corporation (SCCO)
Telefonica S.A. (TEF)
Eli Lilly & Co. (LLY)
Mercury General Corporation (MCY)
Annaly Capital Management (NLY)
American Financial Group (AFG)
WellPoint, Inc. (WLP)
Ares Capital Corporation (ARCC)
Gol Linhas Aereas Inteligentes SA (GOL)