David Dreman is known as the “consummate contrarian” in the world of investing. As the chairman and chief investment officer of Dreman Value Management, he has made a highly successful career out of buying beaten-down, unloved stocks that the market has overreacted to and that are trading at bargain prices.
Dreman’s Contrarian Philosophy
Dreman detailed his contrarian philosophy in his 1998 book Contrarian Investment Strategies: The Next Generation. His approach centers on the belief that investors are prone to overreaction, typically overvaluing the “best” stocks and undervaluing the “worst.” Dreman believed these mispricings could be identified using certain key financial metrics like the price-to-earnings (P/E), price-to-cash flow (P/CF), price-to-book (P/B) and price-to-dividend (P/D) ratios. Stocks with low ratios relative to the market were considered out-of-favor and likely undervalued.
Throughout his career, Dreman used this approach to earn market-beating returns. 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 group from 1988 to 1998, according to Lipper Analytical Services.
Validea’s Dreman-Inspired Model
We have used the detailed criteria from Dreman’s public writings to create a quantitative investment model that follows his contrarian principles. The Validea Dreman model looks for out-of-favor stocks with strong underlying financials. Here are the high-level criteria the model uses:
Look for Contrarian Indicators
To identify contrarian plays, the Dreman model targets stocks in the bottom 20% of the market based on P/E, P/CF, P/B and P/D ratios. It considers a stock a “contrarian” pick if it falls in the bottom 20% on at least two of those four ratios.
Focus on Larger Stocks with Increasing Earnings
In addition to the value metrics, the Dreman model looks for stocks with market capitalizations that place them in the largest 1,500 U.S.-traded stocks. These larger stocks tend to have more staying power and are closely followed by analysts and the media, making them less susceptible to accounting gimmicks, according to Dreman.
The model also looks for stocks with increasing earnings trends and earnings growth that outpaces the S&P 500. These criteria help avoid stocks that are cheap because of underlying business weakness.
Require Strong Financials and Favorable Ratios
Finally, the Dreman model wants stocks with strong balance sheets and financial positions. It looks for companies with current ratios (current assets/current liabilities) greater than their industry average or 2.0, payout ratios that are below their historical average, returns on equity in the top third of the market, pre-tax profit margins of at least 8%, dividend yields at least one percentage point higher than the market, and debt/equity ratios below 20%.
Current Dreman-Favored Stocks
Here are four stocks currently earning high marks from Validea’s Dreman model:
Business: Suncor is a Canada-based integrated energy company. It is focused on developing petroleum resources, while also investing in power generation and renewable fuels.
Dreman Criteria: Trading with a P/E of 8.3, P/CF of 4.6, and dividend yield near 4.2%, SU falls in the market’s bottom 20% for price/earnings, price/cash flow, and price/dividend — hitting on three of the Dreman model’s four contrarian indicators. SU also has a 36% debt/equity ratio, 8% long-term EPS growth rate (vs. 5.2% for the S&P 500), and a 21.6% pre-tax profit margin.
Petroleo Brasileiro SA Petrobras (PBR)
Business: Petrobras is a Brazil-based integrated energy firm engaged in the exploration and production of oil and gas, refining, and electricity.
Dreman Criteria: PBR is in the bottom 20% of stocks based on both the P/E (4.3) and P/CF (2.6), and it also has an impressive 18.6% dividend yield — significantly higher than the market average. The firm has a 29.6% return on equity, 34.7% pre-tax margin, and 97.5% increase in EPS over the long term (vs. 5.2% for the S&P 500).
Business: Bancolombia is Colombia’s largest full-service financial institution, providing a range of banking and financial products to a diversified individual and corporate customer base.
Dreman Criteria: CIB trades with a P/E of 5.4, P/CF of 4.7, and P/B of 0.41, all of which fall in the bottom 20% of the market. It also yields an impressive 9.1%. In terms of financials, CIB has a relatively low 14% debt/equity ratio, a strong 22.2% return on equity, and 73.4% long-term EPS growth (vs. 5.2% for the S&P 500).
Business: Ecopetrol is the largest oil company in Colombia. It engages in the exploration and production of oil and gas, and the refining and transportation of crude oil, natural gas and related products.
Dreman Criteria: EC lands in the cheapest 20% of stocks based on all four Dreman value metrics — the P/E (5.0), P/B (1.2), P/CF (2.5), and P/D (3.55). It has grown earnings at a 49.7% clip over the long term (vs. 5.2% for the S&P 500) and has a strong 22.5% return on equity and 25.7% pre-tax profit margin.
