Contrarian Investment Strategies

by David Dreman

  Figure 11-3 shows the returns of the low-P/E strategy for the forty-one years ending December 31, 2010, using the 1,500 largest companies on the Compustat database.7 The return the investor receives each year is broken down into its two basic components: capital appreciation and dividends.

  The stocks are sorted in the usual manner into five equal groups in each quarter of the study, strictly according to their P/E rankings, and the returns are annualized.8

  Figure 11-3 once again demonstrates the superior performance of the low-P/E group. Over the forty-one years of the study, the bottom P/E group averaged a return of 15.2 percent annually, compared with 11.6 percent for the market (the last set of bars on the right) and 8.3 percent for the highest-P/E group. The lowest P/Es beat the highest P/Es by 6.9 percent a year, almost doubling the annual return over this forty-one-year study. If you’re putting money away for your retirement fund, this performance differential becomes enormous over time, as Figures 10-3 and 10-4 indicated.

  Looking at Figure 11-3 again, you’ll see that these stocks also provided higher dividend yields. As the figure also reveals, the low-P/E group yielded 4.5 percent over the life of the study, compared with 3.2 percent for the market and only 1.4 percent for the highest-P/E group. The dividend return advantage of “worst” over “best” stocks was 3.1 percent annually. On a $10,000 investment over forty-one years, the difference in ending portfolio value between the 4.5 percent yield and the 1.4 percent yield portfolios would be $43,098.

  But look at the appreciation column in Figure 11-3. Something is way out of whack here. The experts say that the “best” stocks, in this case those with the highest P/Es, should have the largest appreciation. But that’s not the case. They have the lowest appreciation, while the investment doggies, the low P/Es, have the highest. All the money that goes into capital expansion for the “best” stocks does not reflect itself in top-gun performance. The down-and-outers once again outstrip the top tier. Low-P/E stocks provide the best of both worlds: higher yield and better appreciation, something that conventional wisdom states shouldn’t happen.

  The higher dividend returns, incidentally, help prop up the prices of cheap stocks in bear markets, one of the important reasons why low-P/E and other contrarian strategies outperform in bad times.

  If you don’t like to trade much, contrarian strategies are for you. Returns stay high with little or no portfolio turnover. Table 11-1 shows how buying stocks in the lowest P/E quintile and holding them for periods of two to eight years over the 1970–2010 period would have done. As a glance at the table shows, the results are rather remarkable. The low-P/E portfolios still provided by far the highest annual returns for the five-year period (15.2 percent), sharply outdistancing the highest-P/E group (9.4 percent), and the market (12.0 percent) The low-P/E returns stayed well above the market and high-P/E returns for both the three- and the five-year periods as well as for eight years.

  It’s surprising that the returns stayed as high as they did for so long. This indicates that the undervaluation of low-P/E stocks is very marked. Holding the lowest 20 percent of stocks for nine years (not shown) still provides above-market returns for the low-P/E group, with virtually no deterioration of performance from year 1. For high-P/E stocks, the overvaluation is just as significant (not shown). Even after five years, they continue to display much lower returns than the market.

  Another advantage of low-P/E and other contrarian strategies is that they don’t require a lot of work to be effective. As we just saw, rebalancing low-P/E portfolios annually with large-sized companies results in far-above-market returns. However, you could rebalance far less frequently. This is a low-intensity strategy with high-intensity results. You don’t have to spend much time agonizing over the stocks you pick and monitoring or interpreting every company, industry, or economic squiggle to divine all-important information. Just select your portfolio (we’ll look at how to do this shortly) and put it on automatic pilot. You’ll save annoyance, not to mention taxes, commissions, and transaction costs, this way. At the same time, you’ll outdistance the market by a comfortable margin, and as you know, few money managers can do that. The point of the chart is not to get you to hold a portfolio intact into eternity but to show that our normal work ethic of constantly being busy to be successful is not useful but often counterproductive in investing.

  Though I wouldn’t buy a portfolio and hold it without looking at it for eight years, Table 11-1 (a large sample of stocks over the last forty-one years) demonstrates that you can make big bucks in the market by positioning yourself carefully at the beginning and fine-tuning moderately thereafter.

  CONTRARIAN STRATEGY 2: LOW-PRICE-TO-CASH-FLOW STRATEGY

  Let’s now look more specifically at another important contrarian strategy, selecting stocks by price-to-cash flow. Cash flow is normally defined as after-tax earnings, with depreciation and other noncash charges added back. Cash flow is regarded by many analysts as more important than earnings in evaluating a company, because management can reduce apparent earnings by setting up reserves or taking write-offs or increase them by not taking adequate depreciation or other necessary charges. Although these entries do not show in earnings, they do read loud and clear in the statement of cash flow, which the Federal Accounting Standards Board (FASB) has required companies to issue since mid-1988.

  All this was changed by new methods of manipulation by companies such as Enron and WorldCom. In the late 1990s, Enron, employing great skill, borrowed money from Citigroup and other banks and showed it, through complex but fraudulently recorded transactions, as cash flow. After Enron collapsed and its auditor, Arthur Andersen, facing criminal charges, voluntarily surrendered its license to practice, the banks paid billions of dollars in damages for their role in the scam. WorldCom improperly accounted for more than $3.8 billion of expenses, dramatically overstating its earnings. In short, if the scammers are good enough, even cash flow can bite you unless you can trust the company. Figure 11-4 provides the results of low price to cash flow.

  CONTRARIAN STRATEGY 3: LOW-PRICE-TO-BOOK-VALUE STRATEGY

  Price-to-book value was a favorite tool of Benjamin Graham and other earlier value analysts,9 and Figure 11-5 gives the results of each. The sample, the time period, and the methodology are identical to those used for price-to-earnings. Looking again at Figure 11-4, price-to-cash flow, and Figure 11-5, price-to-book value, you can see the superior performance of the “worst” stocks, the lowest 20 percent of price-to-cash flow or price-to-book value, over the top 20 percent. The similarity of results is remarkable. The low-P/E strategy is somewhat more rewarding, returning 15.2 percent annually for the forty-one years of the study versus 14.3 percent for low price-to-book value and 14.1 percent for low price-to-cash flow.

  But all three value strategies handily beat the market and sharply outperform the “best” stocks in each case. Once again, we see the key ingredients of outperformance: low price-to-cash flow and low price to book value have significantly higher dividends than the market and more than triple the dividend of the “best” stocks in each category, providing a good contribution to total return. Too, look at the appreciation of the low-price-to-cash-flow and low-price-to-book-value groups. By this measurement, both groups handily outperform not only the most favored stocks but also the market. The accepted reason for buying “best” stocks, much higher appreciation, is thus shown to be fallacious.

  Figures 11-3, 11-4, and 11-5 again demonstrate that contrarian stocks give you the best of both worlds: higher appreciation and higher dividends. The bottom quintile provides dividend returns three times as large as the highest-P/E quintile, another easy win for out-of-favor stocks.

  Figures 11-3, 11-4, and 11-5 demonstrate that the conventional wisdom of setting radically different investment goals for conservative and aggressive investors is simply one more investment myth. Which brings us to another important investment Psychological Guideline:

  PSYCHOLOGICAL GUIDELINE 23: Don’t speculate on highly priced
concept stocks to make above-average returns. The blue-chip stocks that widows and orphans traditionally choose normally outperform the riskier stocks recommended for more aggressive businessmen or-women.

  Stocks classified as “businessman’s risk” by many brokerage firms, because of their low dividends and high price-to-book-value ratios, often turn out to be losers. As a group, they consistently underperform the market. A better term might be “businessman’s folly.” Figures 11-3, 11-4, and 11-5 go far to disprove the concept of “businessman’s risk” for buying stocks. It still might be an “all-American” concept, but it is far less widespread today, touted primarily by brokers, who pick up more in commissions.

  The strategy of buying the lowest 20 percent of stocks by either price to book value or price to cash flow, as we have seen, holds up through both bull and bear markets. Buying and holding portfolios of the lowest-price-to-cash flow and lowest-price-to-book-value stocks without any change in their composition for periods of two, three, five, and eight years (not shown) provide returns very similar to those of buying and holding the lowest-P/E portfolio (Table 11-1). Investing in these two groups results in returns well above the market’s and sharply higher than the favored stocks in each group for every period up to eight years.10 The “best” stocks continue to underperform for these extended periods.

  Again we see that you don’t have to watch the market like a gunslinger, ready to slap leather at any new piece of information. Relax; you’ll probably make far more by taking your time. And there is the collateral reward of not shooting yourself in the foot by moving quickly and incorrectly, as is often the case with the pros.

  The final reward, and one of the most important, of the buy-and-hold approach, as indicated with low-P/E or the other low-price-to-value strategies, is that lower transaction costs and taxes can result in a substantial increase in your capital over time. Transaction costs are often not recognized by investors but can add up, particularly on less liquid stocks. What these three low-price-to-value strategies can do for you over time, then, is provide returns high enough that only a minimum of trading is required, thereby reducing, perhaps substantially, these costs and enhancing your portfolio returns. This leads us to another helpful Psychological Guideline:

  PSYCHOLOGICAL GUIDELINE 24: Avoid unnecessary trading. The costs can lower your returns over time. Buy and hold strategies provide well-above-market returns for years and are an excellent means of lowering turnover and thereby significantly reducing taxes and excess transaction costs.

  The three major strategies show markedly superior returns for “worst” stocks while avoiding extra trading costs. Finally, since yield is a very important factor for many readers, let’s look at the high-yield strategy.

  CONTRARIAN STRATEGY 4: HIGH-YIELD STRATEGY

  Figure 11-6 provides the annual returns of high-yield strategies. The method and period used are the same as those for the previous three strategies. As the chart indicates, however, high-yielding dividend strategies perform somewhat differently from the previous contrarian strategies. The highest-yielding stocks outperform the market by 0.9 percent and the stocks with low or no yield by 4.0 percent annually.

  However, the composition of the returns is different. More than half of the 12.5 percent annual return of the highest-yielding group comes from the yield itself. Moreover, appreciation, at 6.0 percent annually over the forty-one-year period, is lower than for any of the other “worst” groupings or for the market. Buying stocks with high dividend yields beats the market but provides lower total returns than the previous three contrarian strategies.

  Once again a buy-and-hold strategy works well for the lowest-price-to-dividend group. Not only do you continue to beat the market over time with this method, but your returns actually increase with a longer holding period.*62 The average yield, as shown in Figure 11-6, was 6.5 percent annually through the study. Also of note is that the dividend rate increases with time and may yet surprise us again as recessionary conditions slacken.

  For investors who require income, this appears to be a far better strategy over time than owning bonds. If interest rates spike up, bond prices will go down sharply. The price of a thirty-year bond, for example, will drop 12 percent for every 1 percent increase in interest rates. With the wide fluctuations of interest rates in recent decades, the bond market has actually been almost as volatile as the stock market. Buying high-yielding stocks makes good sense for the yield-conscious investor. Dividends go up over time; interest payments on bonds do not. Yes, we are in a highly abnormal period today, with short Treasuries yielding almost nothing. But, as chapter 14 will detail, this is likely to be another bad trap for investors.

  High-yielding stocks also provide you with the best protection in most bear markets, as we saw in Figure 10-5a. These stocks give the dividend-oriented investor more protection of principal on the downside and often provide both rising dividend income and capital appreciation; the latter occurs only rarely with long bonds.*63 However, this strategy does not always work, as we know all too well from the horrific bear markets, such as 2007 and 2008, followed by 2009–2010, when the dividends of many high-yielding stocks were cut to the bone and people traded even relatively secure dividend income for the absolute, albeit temporary, security of Treasuries. Fortunately, a bear market of this magnitude and severity occurs only once in generations.

  Is this strategy for everyone? I don’t think so. It works best for people who need a constant source of income. Naturally, unless you hold the stocks in a tax-free account, the income is taxable. And in a tax-free account an investor is far better off using one of the three other contrarian strategies—depending of course on immediate income requirements—which, as we saw in Figures 11-3, 11-4, and 11-5, provide significantly higher returns over time than the high-yield strategy.

  Value, then, in the form of contrarian strategies, is the closest thing there is to a strategy for all seasons in the stock market. Now for some application guidelines that will help you implement various contrarian strategies.

  Section III. Contrarian Strategies in Action

  1. CONTRARIAN STOCK SELECTION: THE A-B-C RULES

  The initial problem confronting all investors is how to select individual stocks and the number of stocks to hold in their portfolio. A few simple guidelines have proved their worth over the years:

  A. Buy only contrarian stocks because of their superior performance characteristics.

  B. Invest equally in thirty to forty stocks, diversified among fifteen or more industries (if your assets are of sufficient size).

  Diversification is essential. The returns of individual issues vary widely, so it is dangerous to rely on only a few companies or industries. By spreading the risk, you have a much better chance of performing in line with the out-of-favor quintiles shown above, rather than substantially above or below that level.11

  C. Buy medium- or large-sized stocks listed on the New York Stock Exchange or only larger companies on NASDAQ or the AMEX.

  Such companies, upon which the studies have been based, are usually subject to less accounting gimmickry than smaller ones, and this difference provides some added measure of protection. Accounting, as we have seen, is a devilishly tricky subject and has taken a heavy toll on investors, sophisticates as well as novices.

  Larger- and medium-sized companies provide investors another advantage: they are more in the public eye. A turnaround in the fortunes of Ford (which occurred in 2009) is far more noticeable than a change in the fortunes of some publicly owned steak restaurant franchise buried, say, in the sand and wind of Death Valley. Finally, larger companies have more “staying power”; their failure rate is substantially lower than that of smaller and start-up companies.12

  2. SHOULD WE ABANDON SECURITY ANALYSIS ENTIRELY?

  As we have seen, selecting stocks by their contrarian characteristics and placing no reliance on security analysis has given better-than-average returns over long periods of time. Should we, then, consider abandoning s
ecurity analysis entirely? The evidence we’ve seen certainly shows that it doesn’t help much. However, I would not go quite this far (and not just because I’ve been thoroughly steeped in the doctrines of the Old Church). I believe parts of it can be valuable within a contrarian framework.

  Contrarian methods eliminate or downgrade those aspects of traditional analysis, such as forecasting, that have been shown to be consistently error-prone. By recognizing the limitations of security analysis, you can, I believe, apply it to achieve even better results within the contrarian approach. However, for a lot of you, a well-diversified contrarian index fund built on the principles in this book would be a solid way to invest. Unfortunately, there are very few out there to choose from. Our firm manages a series of contrarian index funds from large cap to midcap to small cap.*64 Why there are so few baffles me. Over thirty years, contrarian performance has sharply outperformed the market and the various index funds out there, from small to mid to large. It’s an idea whose time has come, but it does require a pretty careful reading of the funds’ prospectuses as well as a thorough watch over their portfolios to make sure the fellers are actually managing the money the way they say they are.

  In the next sections, I’ll attempt to show you how five fundamental indicators can be used to supplement the A-B-C Rules of contrarian selection we just looked at. Following this analysis, we’ll examine other contrarian methods that do not depend on security evaluation. These, too, should provide above-average market results. After reviewing the various methods, you can choose which suits you best.

  3. FIVE SELECTION INDICATORS