Contrarian Investment Strategies

by David Dreman

  In my own application of the low-P/E approach, I select from the bottom 20 percent of stocks according to P/E. The lowest quintiles provide plenty of scope for applying the ancillary indicators that follow.

  If, after what you’ve seen, you are brave enough to dabble in security analysis, here are the indicators I consider most helpful:

  Indicator 1. A strong financial position. This card is essential in today’s market, where liquidity is hard to find. This is easily determinable for a company from information contained within its financial statements. (The definitions of the appropriate ratios—current assets versus current liabilities, debt as a percentage of capital structure, interest coverage, and so on—can all be found in any textbook on finance, as well as in material provided free of charge by some of the major brokerage houses.)*65

  A strong financial position will enable a company to sail unimpaired through periods of operating difficulties, which contrarian companies sometimes experience. Financial strength is also important in deciding whether a company’s dividends can be maintained or increased. And of course in a liquidity crisis, such as the one that we have just gone through and that continues to linger, it is often the difference between survival and insolvency. Mercifully, serious crises of this sort occur only every century or so, or did. In any case, companies with financial strength not only survive but often prosper in such times. Look no farther than Warren Buffett’s Berkshire Hathaway.

  Indicator 2. As many favorable operating and financial ratios as possible. This helps ensure that there are no structural flaws in the company. Again, the definitions of such ratios can be found in standard financial textbooks.

  Indicator 3. A higher rate of earnings growth than the S&P 500 in the immediate past and the likelihood that it will not plummet in the near future. Such estimates are an attempt not to pinpoint earnings but only to indicate their general direction. Remember that we are dealing with stocks in the bottom quintile, for which only the worst is expected. Unlike those who use conventional forecasting methods, we do not require precise earnings estimates; we need merely note their direction and only for short periods, usually about a year or so.

  In my initial contrarian work, I was more of a purist on this subject. I thought: since contrarian strategies worked at least in part because of analysts’ errors, why bother with forecasting at all? Some rather harsh experiences have caused me to modify this position.

  If, for example, the Street estimates that a company’s earnings are likely to be down for some time, I would not rush in to buy, no matter how positive my indicators appear to be. Often, as we’ve seen, analysts are overoptimistic. All too frequently, an estimated moderate decline in earnings turns into a drop off a cliff. This was the case with many of the financial stocks, from Citigroup to Wachovia to AIG, in 2007–2008, when the analysts were making estimates of relatively small declines in earnings, but those companies’ income had actually fallen off the cliff.

  The important distinction between forecasting the general direction of earnings and trying to derive precise earnings estimates is that the former method is far simpler and the probability that it will succeed much higher.

  Indicator 4. Earnings estimates should always lean to the conservative side. This ties in with Graham and Dodd’s margin of safety principle, even more so after our frightening trip through the lands of overoptimistic analysts. Sometimes you don’t need a pencil to recalibrate estimates to lower, more realistic levels; you need a large excavator to drop them down into their proper subterranean place. Remember, too, that by relying on general directional forecasts and keeping them ultraconservative, you are reducing the chance of error even further. If you do this and the company still looks as though its earnings will grow more quickly than the S&P for a year or so, you may have a potentially rewarding investment.

  Indicator 5. An above-average dividend yield, which the company can sustain and increase. This indicator depends on Indicators 1 through 4 being favorable. We have seen that conventional thinking about dividends is far off the mark. High-yield strategies also outperform the market. In practice, I have found that Indicator 5 improves performance when used in conjunction with the primary rules of buying contrarian stocks.

  Now that we have looked at five indicators that should prove helpful regardless of the contrarian strategy we use, I’ll turn briefly to another matter. A question I’m frequently asked is “What is the best approach to contrarian investing? Is it better to select one method, such as price to earnings or price to book value, and focus solely on it?” For me, the answer is no. Though you can certainly select one strategy and run with it successfully, once again I favor a more eclectic approach. Our money management firm uses the low-P/E method as its core strategy but also utilizes the other three contrarian strategies extensively. Investment opportunities vary, and often you can find exceptional value with one method that does not show up as clearly with another.

  Low P/E is probably the most accessible of the four contrarian strategies, because the information on P/E ratios is available daily in the financial section of any large newspaper, next to a stock’s price. The information is also updated quarterly, as are price-to-cash flow and price-to-book value. Though price-to-dividend information is also nearly instantaneous, it is a secondary strategy because of the superior returns of the first three contrarian methods. However, it, too, has its moments in the sun, as we shall see.

  4. CONTRARIAN STRATEGIES IN ACTION

  To the Front

  It’s time to move into the trenches to see how contrarian decisions are made under fire. I’ll draw on past recommendations I’ve made in my Forbes column and to the clients of our investment counseling firm, as well as examples from the Dreman High Opportunity Mutual Fund, which I manage. Though one can be accused of telling “war stories,” remembering only the victories while conveniently forgetting the setbacks (not to mention the routs), I think that it helps to present practical examples of how the A-B-C Rules and five indicators often had clear-cut results—not only with 20/20 hindsight but at the time. Our first stop will be a couple of examples of how we’ve selected low-P/E stocks.

  Using the Low-Price-to-Earnings Strategy

  Altria Group

  I recommended Altria Group ($49), the parent of Kraft Foods as well as Philip Morris, in Forbes in late September 2004. Here was a classic value stock and one that was heartily disliked by a good part of the public because of its ownership of Philip Morris, the nation’s largest cigarette manufacturer, which at the time was undergoing several large class action suits. After carefully researching the class actions, we came to the decision that the cases, although generating major headlines about potentially devastating losses, were unlikely to cause serious damage to Altria with its rock-solid financial position and enormous cash flow.*66

  This was the kind of stock that Benjamin Graham might have dreamed of. First, its P/E and price-to-cash-flow ratio were extremely low in 2003, at the time 10х and 9х, respectively. Moreover, it yielded 6 percent back then and had raised its dividend almost every year since the 1930s. Indicators 1, 2, and 5 were almost off the charts. But there was more.

  Although Altria was under heavy legal and media assault, all the lawsuits were against the U.S. tobacco subsidiary (Philip Morris USA). When we added up the combined operations of Altria, their value, by what we considered conservative accounting, came to roughly $105 a share, with Philip Morris’s domestic value about $45, or 43 percent of our estimate of the value of the total operation. So great were the unfounded fears of the enormous size of the legal settlements that the company was trading at a larger than 60 percent discount to its real worth. Moreover, the U.S. Supreme Court was growing concerned about the size of the punitive damage awards to plaintiffs above actual damages claimed, sometimes reaching ten or even a hundred times the damage claims themselves. The Court’s concern was the size of damage awards across the board.

  Our analysis was extremely thorough, particularly examining the pote
ntial for bankruptcy, which appeared very far-fetched. The Supreme Court dramatically lowered the amount that could be paid above actual damages and also tightened the rules significantly on class actions, another major benefit to Philip Morris. By March 2008, the share price more than doubled in value, including dividends.

  Apache Corporation

  With the demand for oil outstripping new supply since 1982 and the last million-barrel-a-day field found in Kazakhstan in 1979, oil prices had moved up fairly steadily over time until late 2008. One of the most promising industries, if oil prices rose, was the large exploration and development companies that have large oil and reserves, a good portion of them domestically. Similarly, they would perform worse than the large integrated companies, such as Exxon Mobil, Royal Dutch/Shell, or BP, if prices came down. I recommended the purchase of Apache in Forbes on July 25, 2005, at $65, when it was at a P/E of 11х, significantly below that of the market.

  At the time Apache was cash rich and held major reserves. The company was rapidly increasing its spending on finding new oil and gas. Its programs in discovering major new oil in recent years, in relatively safer areas of the globe, had proved very successful.

  The company spent its exploration money wisely, and its reserves grew handsomely. By the end of 2007, its price was up 70 percent from the time of the Forbes recommendation, in a market that was starting to turn down sharply. Apache was also strong, as measured by the first three indicators, and met all its objectives in a so-so market.

  In 2008, the worst market collapse since 1929–1932, Apache was hit hard; with the price of oil plummeting, the stock fell to a low of $51 in early 2009 but rebounded sharply beginning in the spring of 2009. Oil prices spiked up again to $110 a barrel in the winter of 2011, and Apache shot back to $130. It has also taken advantage of a major opportunity. During the BP oil spill in the summer of 2010, it was able to buy major additional reserves from BP valued at $7 billion in fields in Canada and Egypt, as well as the Permian Basin, at what were considered to be bargain prices.

  Apache was a good example of buying strong value and holding on to it through a disastrous market, because the basic reasons for doing so had not changed—that is, unless you believed another Great Depression was on our doorstep. (See Figure 11-7.)

  Using the Low-Price-to-Cash-Flow Strategy

  BHP Billiton

  Low price to cash flow, as Figure 11-3 demonstrated, has also provided well-above-average returns over time. Price to cash flow is often a more useful measure than earnings when a company has large noncash expenses, such as depreciation in bad years.*67 If you try to buy normally low-P/E cyclical stocks in a recession, when the earnings of such companies tumble, the P/Es can get very high. This happened to BHP Billiton, one of the world’s largest natural resource producers, which I recommended in Forbes in February 2009, at $48. Although the company had relatively strong finances, its earnings began to collapse as the worldwide recession almost brought the purchase of most natural resources to a screeching halt in the last months of 2008. BHP’s earnings dropped 62 percent, from their record high of $5.11 in fiscal 2008 (ended June 30) to $2.11 in fiscal 2009, and the company’s cash flow also dropped about 50 percent, but with its strong cash flow in prior years and its financial strength this was more than adequate to cover the company’s requirements.

  Once again stories were spun out in the financial pages, and sometimes on front pages, of how major industrial firms and mines might take years to recover. Apparently forgotten was that BHP was one of the lowest-cost producers of natural resources globally. With the mild recovery, earnings and cash flow bounced back strongly in 2010, in line with where they had been in its second best year, 2007. By December 2010, BHP, trading at $93, had almost doubled from the price at which I had recommended it in Forbes. So strong was its cash flow that it raised its dividend rate 50 percent in 2008 and another 17 percent in 2009. That BHP increased its dividend at all, rather than markedly, indicated management’s confidence that the company was rock solid because of its financial strength, despite the sometimes frightened comments by both analysts and the press. (See Figure 11-8.)

  And a Strikeout!

  Fannie Mae

  Fannie Mae, a blue chip for generations, appeared to be a cheap stock trading at $37 near the end of 2007, when it was recommended. The company had had above-average earnings growth for decades. True, the mortgage market for subprime and other riskier mortgages was dropping rapidly, the company had been running at a loss for several quarters, and there were slick roads ahead, but Fannie had been through numerous bad housing markets since it was founded by the Roosevelt administration in 1938. The company and its somewhat smaller counterpart, Freddie Mac, had much tighter credit standards than the banks, the S&Ls, and the investment banks. An examination of their default ratios confirmed that over time their credit standards had been much higher for buyers to qualify for mortgages, and their default ratios had been much lower. The stock was purchased because it had a strong mandate, a protected business model, and historically good earnings growth, as well as a low P/E ratio.

  What was not known at the time or in subsequent interviews with senior management, including the chairman of the board, was that the pastoral landscape the executives painted verbally was far removed from the facts. Under severe pressure from both the Democrats, led by Congressman Barney Frank, and the Bush administration, led by James B. Lockhart III, the head of the Federal Housing Finance Agency (FHFA), which regulated Fannie and Freddie, enormous political pressure was put on Fannie and Freddie. They were repeatedly threatened with the loss of their vital low-cost financing if they didn’t make increasingly larger amounts of mortgages available to lower-income groups.

  In the spring of 2008, both Treasury Secretary Hank Paulson and New York Fed president Tim Geithner indicated that both companies had excess capital above their regulatory capital requirements. Geithner announced that because Fannie and Freddie’s operations were improving, he was reducing their capital requirements so that they could loan even more to the rapidly falling mortgage market. He made similar announcements through August 2008, with, it appeared, at least the tacit approval of Treasury Secretary Paulson.

  Then, on September 6, 2008, both companies were put into receivership by the U.S. Treasury; they now trade for only pennies. In a subsequent announcement it became clear that both Fannie and Freddie had buckled under the intense pressure they were facing and had put substantially more money into “NINJA” (no income, no job or assets) mortgages, often with virtually no down payment. Naturally, all the senior Fed, administration, and congressional officials walked away, blaming Fannie for its poor lending practices. The carnage continued, and the S&P 500 Financial Select Sector SPDR (the market weight of all financial stocks in the S&P 500) dropped 83 percent from 2007 to early March 2009, the largest decline since the 1929–1932 crash and in a shorter period.

  What went wrong with our analysis and those of most value managers of Freddie and Fannie, the banks, and the investment banks? Here are a couple of important lessons which I have extracted from this painful experience:

  1. Never buy a company that is losing money. Losses are an early-warning system that all is not well. Most good companies do turn around, but when they don’t you get stung. The contrarian studies that we looked at always excluded companies that had an earnings loss in any quarter, and the results over time were just fine.

  2. This one is hardly worth writing about but inevitably takes a major toll. Never, never believe senior officials up to the cabinet level when they say all is well in trying times for a company or an industry. In most cases that’s the time to let the stock or industry go. (See Figure 11-9.)

  Using the Low-Price-to-Book Value Strategy

  JPMorgan Chase

  Price to book value, even more than price to cash flow, is an excellent contrarian indicator when a company stumbles and earnings crater. A good example was the bank stocks in the financial crisis of 2007–2008. As the subprime cris
is intensified, financials, as we saw, plummeted. JPMorgan Chase, under Jamie Dimon, its savvy CEO, was one of the first of the major banks to recognize the gravity of the subprime situation, and in 2007–2008 it began to both lessen its activities in those markets and reduce its sizable portfolio of those and other lower-rated mortgage holdings. Its price to book value was substantially lower than the market’s, as were those of most financial stocks.

  But there was one major difference: JPMorgan Chase’s book value was by and large real. Because of its greater liquidity as a result of its pulling back on the purchase of illiquid mortgages, the Federal Reserve and the Treasury struck an advantageous deal with it that allowed it to buy Bear Stearns, one of the largest Wall Street investment banks, on Sunday, March 16, 2008. The price was $2 a share,*68 a 93 percent discount from where Bear had closed the previous Friday. Although there were other bidders, JPMorgan Chase was the only credible contender and got a sweetheart deal from the Fed, paying only $1.5 billion for the firm, whose assets included its headquarters building, worth an estimated $1.2 billion. The Fed also agreed to fund up to $30 billion of Bear Stearns’ troubled assets as well as provide it with special financing for the transaction.13 The purchase gave JP Morgan Chase a major foothold in the investment banking business, where it had lagged behind other major competitors.

  If lightning is not supposed to strike twice in one spot, there is no such idiom about “white magic.” In late September 2008, the FDIC, after a bank run on Washington Mutual (WaMu), sold the nation’s largest thrift to JPMorgan Chase for approximately $1.9 billion. Included in the sale were $307 billion in assets, $188 billion in deposits, and 2,200 branches in fifteen states.14 To put the size of the WaMu sale into context, the company’s assets were equal to about two-thirds of the combined book values of all the 747 thrifts that had been sold off by the Resolution Trust Corporation, the government body that had handled the savings and loan crisis from 1989 through 1995.15 The deal vaulted JPMorgan Chase into first place nationwide in deposits.