Contrarian Investment Strategies

by David Dreman

  The company’s strong price-to-book-value ratio and the high quality of its financial assets allowed it to build a financial empire. True, it was tough sledding for a while. In March 2009, it traded at just over 40 percent of book value, at $16. But by April 2010, it was once more above $45.

  The enormous advantages of expanding profitability: it added the largest branch banking systems in the country; and a fully integrated investment banking department, given to it by the regulators for pennies on the dollar, was achievable only because of its financial strength. These acquisitions will be likely to lead to major payoffs over time. (See Figure 11-10.)

  Using the High-Yield Strategy

  Southern Company

  The high-yield strategy, as we have seen, also provides above-average returns. At its most effective, it can be used with other contrarian methods to ferret out undervalued stocks, providing a combination of above-average income and reasonable appreciation. As noted, a high yield, even if earnings are temporarily depressed, indicates management’s confidence in the future. How management and the board of directors react to a serious problem is usually worth noting.

  At times the utility stocks are an example of a group where a combination of high yield and low P/E allows investors to score well. High yield also works well in tandem with low price to book value.

  This brings us to Southern Company, a utility company that operates four utilities with 4.4 million customers in Georgia, Alabama, Florida, and Mississippi. The company has shown slow but reasonably consistent growth for years. Every once in a while, as with most utilities, its stock price dips because of minor concerns that dissipate shortly thereafter. One such case came in mid-2002, when Southern’s stock fell to $24, where it traded at a P/E of 13х and yielded 5.6 percent. The stock’s earnings and dividends continued to grow over the next 51/2 years, together returning 109 percent through 2007, when it yielded 7 percent on its original purchase price. Investor overreaction, as this example shows, is not confined solely to high-volatility stocks; utility and consumer nondurable buyers also get their chance on occasion. (See Figure 11-11.)

  Contrarian Strategy Performance Summary

  All five of the successful examples—Altria Group, BHP Billiton, Apache Corporation, JPMorgan Chase, and Southern Company—demonstrate a beneficial side effect of these strategies. Often contrarian stocks can move substantially higher in price and still be good holdings. The reason: earnings are moving up rapidly enough that the P/E, price-to-book-value, and price-to-cash-flow ratios remain low.

  The contrarian approach I present has worked well both for my clients and for myself over time. Though I would be the last to argue that the record is definitive, the strategy has succeeded through both bull and bear quarters.16 Although the degree of success will certainly vary among individuals—and for the same individual over differing time periods—this approach seems to be an extremely workable investment strategy, eliminating most complex judgments.

  Indicators 1, 2, 4, and 5 are reasonably straightforward calculations, avoiding the major portion of Affect, configural, and information-processing problems previously discussed. And Indicator 3, which projects only the general direction of earnings, is much simpler and safer to use, and consequently should have a better chance of success, than the precise estimates ordinarily made by security analysts. Obviously, this is one of the methods I favor most.

  As an investor, you may choose to follow this strategy as I have laid it down or look at other variations in the next chapter that should also allow you to outperform the market. But before you do this, let’s visit the contrarian casino. You should really like this one because the odds in the casino favor the players. In fact, the question is: who really owns the casino?

  Section IV. What Are the Probabilities of Success Using IOH?

  FINDINGS

  At this point I think I hear a few murmurs out there—and rightly so. There are zillions of how-to investment books touting this method or that. Are there any real odds that contrarian strategies will beat the market over time? Indeed there are.

  Calculating the returns of our forty-one-year study of the 1,500 largest stocks on the Compustat database, we find that the odds of contrarian strategies’ outperforming the market are about sixty–forty in any single quarter. The casinos in Las Vegas and Atlantic City make a bundle with odds 5 to 10 percent in their favor. The probabilities of beating the averages using contrarian strategies, then, are even higher than the casinos’. Let’s look at these probabilities in detail. The results, I think, will surprise you.

  First, in investing, unlike in Las Vegas, even if you do only as well as the market, you will walk away with your pockets bulging. You don’t just get your cash back; you get it compounded. Ten thousand dollars invested in the market, as Figure 10-3 showed, results in a portfolio value of $913,000 forty-one years later. In the market casino, just breaking even would give you ninety times your money in forty-one years.

  However, Figure 10-3 also demonstrated how well you would have done in contrarian strategies over time. Using the low-price-to-cash-flow strategy, you would have more than doubled the performance of the market, increasing your $10,000 of initial capital 216-fold. With price to book value, you would have outperformed price to cash flow somewhat, increasing your capital a modest 242 times. Investing in stocks produces enormous returns, even if you do only as well as the market. If you adopt a contrarian strategy, the results are spectacular.

  You may have some questions at this point. First, is forty years a realistic time frame? How many people invest for anything near this time? If you are in your twenties or thirties, twenty-five or thirty years is not unreasonable, particularly if you are building your nest egg in an IRA or another retirement plan.

  But as Table 11-2 demonstrates, you also get mouthwatering gains for shorter periods. The table indicates the amount that $10,000 would become in periods of five to twenty-five years relative to the market using the four contrarian strategies we have examined.17 As you can see, all four strategies whip the market in every period. And the percentage they do it by goes up dramatically with time. Low P/E had the best returns overall. In five years, using the low-price-to-earnings strategy, you outdistance the market by 18 percent. This rises to 69 percent in fifteen years and 101 percent in twenty. And look at the difference compounding makes. At the end of five years, again with the price-to-earnings measure, the return is $3,203 over the market’s; by ten years it increases to $12,419; and by the end of twenty-five years to $209,687. Remember, this is an initial onetime investment of only $10,000.

  “There’s no question that contrarian strategies look impressive, if not overwhelming, in studies,” some readers would say, “but what are my chances of beating the market in practice?” Then there are other problems to deal with, such as the 2007–2008 crash, which cut out a large chunk of most people’s retirement and savings plans.

  Again, let’s look at our chances of outdistancing the market over time in terms of the odds at a casino. Using our forty-one-year study,18 we know that the odds are sixty–forty in our favor in any single play. But what are they over a large number of hands? In market terms, that would mean playing these strategies over some years.

  To determine the answer, we use a statistical calculation, not by coincidence called the Monte Carlo simulation. We treat each quarter as a single card. Since we have a forty-one-year study, we have 164 quarters. Using low P/E as our strategy, we randomly pick a quarter from the 164 quarters in the forty-one years and calculate the return against the market, whether it is positive or negative. The card is then put back into the 164-quarter deck. We then randomly select another card in the same manner, calculate the return, and again put it back into the deck. This allows any quarter to be drawn more than once and other quarters to be missed entirely.

  In effect, we are taking any possible combination of market returns over the 164 quarters of the study to determine just what the probabilities of beating the market are. A game woul
d consist of 100 draws for each hand, which would total twenty-five years.19 This gives us an almost unimaginably large number of combinations, which provides very accurate odds of how well a strategy will work over time. The Monte Carlo simulation allows us to get billions of possible combinations (actually 164100, or more than the number of inches from here to the Andromeda galaxy, which is two million light-years away).

  But most investors don’t make a onetime investment in the market; they put away a few thousand dollars or more each year. Not wanting to bore the computer, we asked it to calculate the odds of beating the market for 10,000 plays of each strategy, investing sums from $1,000 to $20,000 dollars annually. The computer did this for the four value strategies, with only a minor whine at the monotony.

  Table 11-3 shows the result of investing these amounts using the low-P/E strategy against the market over time. As you can see, the dollars you accumulate using a contrarian strategy are almost mind-boggling. An investment of only $1,000 a year over twenty-five years in a tax-free account would become $262,709. An investment of $20,000 a year would, by the same method, become $5,254,173.

  If you used the low-P/E strategy and repositioned your portfolio quarterly into the lowest-P/E group, what would be your odds of beating the market over twenty-five years? High enough to make the owner of the plushest casino drool. If you play a 100-card series 10,000 times, your probabilities of winning are 9,978 out of 10,000! That’s right, chances are you would underperform the market only twenty-two times in 10,000, or about two tenths of 1 percent on each hundred-card play.20 And remember, this casino is different; even underperforming the market sends you away not with empty pockets but with a large stack of chips if you get even a reasonable percentage of the market’s return.

  But say that twenty-five years is much too long for you to invest—what would happen if you move to a ten-year span? Using this strategy for ten years would reduce your chances of beating the market, but not by much. You would still come out a winner 9,637 times out of every 10,000 hands you played, not bad in casinos or markets. If you invested for five years in this manner, your odds of beating the market would still be 90 out of every 100 hands. The probabilities of winning with this strategy are a gambler’s or an investor’s fantasy.

  But let’s stop for a moment. Maybe you don’t like to turn a part of your portfolio each and every quarter. Such a strategy might be too anxiety-producing; it might drive you, along with the rest of the players, to Prozac. How do we do if we opt for a longer holding period, say a year, without changing any part of the portfolio? Once again, this casino pays off like a dream. If you play this strategy for one-year periods for the full length of the study, making modest changes to the portfolio annually, your odds go up. But I’m sure you’ll take them—try winning 9,998 of 10,000 hands. If you want to go for shorter periods, your odds of beating the market decrease somewhat but are still high—99 percent for ten years and 94 percent for five years.

  The probabilities are nearly identical for price to cash flow and price to book value. A casino owner would die for these odds rather than the roughly fifty-five–forty-five the house gets. In fact some casino owners, including “Bugsy” Siegel, pushed daisies for far lesser odds.

  These odds are by far the highest consistently available of any investment strategy I am aware of. There is nothing closer to a sure thing for millions of investors, yet, strangely enough, few play this game.

  The contrarian wing has always been sparsely populated, and, despite all the statistics, it’s likely to remain so.

  Walking Away from the Chips

  It’s important to realize that investing using contrarian strategies is a long-term game. One roll of the dice or a single hand at blackjack is meaningless to a casino owner. He knows there will be hot streaks that will cost him a night’s, a week’s, or sometimes even a month’s revenues. He may grumble when he loses, but he doesn’t shut down the casino. He knows he’ll get the money back.

  As an investor, you should follow the same principle. You won’t win every hand. You’ll have periods of spectacular returns and others you might diplomatically describe as lousy. But it’s important to remember that contrarian strategies, like a casino’s odds, put you in the catbird seat. Professional investors, along with everyday folks, often forget this important principle and demand superior returns from every hand.

  Even though a strategy works most of the time and generates excellent returns, no strategy works consistently. The fast-track, aggressive growth stocks will, on occasion, knock the stuffing out of low-P/E or other contrarian methods for several years at a clip—sometimes for much longer, as they did between 1996 and early 2000. But over time, it’s simply no contest. Low P/E came back strongly in 2000 and 2001, sharply outperforming growth for the preceding ten years. Still, human nature being what it is, our expectations are almost always too high.

  Is it possible for everyone to handle contrarian strategies? I’m confident that the underlying psychology we’ve looked into in some detail will remain valid, and I think most of us would take the bet that human behavior is remarkably invariant. But attitudes do change, and strong market movements, particularly by groups of exciting stocks, invariably bring about changes in the way people think. It is very hard for many, no matter how much they know, to take the odd cold shower while everyone else seems to be having a great time in the Jacuzzi.

  It’s almost impossible to underestimate the power of Affect, neuropsychology, and other psychological influences on our decisions. As a trained professional investor well versed in the new psychology, I’m certainly not immune, nor is anyone else. Enthusiasm, despondency, and fear tug at me just as hard as at most people, but knowledge gives you a better hand far more often than not. Still, it’s no whitewash.

  Even when we look at the record of these superb returns, which encompass both bull and bear markets over decades, we are still disappointed that a contrarian strategy doesn’t win each and every year. The probability is very low that any investment strategy will, just as it is that you’ll win a hundred straight hands at blackjack. That’s obvious—if we were totally rational data processors. But we are not. We demand the impossible and repeatedly make poor decisions in pursuit of the unattainable.

  Take the following example of how easily a winning strategy can be abandoned. In 1998 and 1999, growth investing sharply outperformed the value approach. Many value managers trailed the S&P 500 by 14 or 15 percent when the market was up 56 percent in the 1998–1999 period. These strategies continued to underperform for several years. The chant went up from some consultants and sophisticated clients that value was dead. “Contrarian strategies might have worked well in the past,” many said, “but now, with almost everyone using them, they aren’t effective anymore.”

  Then contrarian strategies did the unthinkable—they underperformed by even more in the first two months of 2000. How could this happen? Fidelity Investments replaced its leading contrarian manager, George Vanderheiden, in early 2000 with a growth team. Vanderheiden had managed the $7.2 billion Fidelity Destiny I fund as well as two other funds for almost twenty years.

  The over $4 billion contrarian fund I was managing saw its assets drop by almost 50 percent as shareholders fled to hot Internet and fast-growing dot-com funds. The underperformance by contrarian stocks was worse than I had ever experienced. I wondered how many years it would take for me to catch up with the high-flying NASDAQ market, where the large majority of those hot stocks traded.

  The answer was not years but months. By mid-March, the Internet bubble began to disintegrate and dot-com and high-tech stocks plummeted. Concurrently, Dreman Value Management’s contrarian portfolios and mutual funds skyrocketed. By the end of 2000, our portfolios were up 40 percent, while the S&P 500 dropped 9 percent. We had made up not only all the underperformance we had lost between 1997 and 2000 in a little under ten months but a good deal more. As for George Vanderheiden, a Wall Street Journal article written several years later calculated that ha
d his original portfolio been left intact, the fund he had managed so successfully over time would have been 40 percent above where it was under the new managers.

  Again, it was simply the laws of probability. Contrarian stocks have an excellent record of doing better in bear markets, but that doesn’t mean they will do so every time (they don’t have to in order to get the well-above-average returns we saw in bear markets in Figure 10-5a). Still, when they don’t do better, consultants and professionals, as well as individual investors, believe the strategies have lost their edge. Large numbers of investors, from giant institutions to individuals, abandoned them at that point, which happened to be right at the bottom of their performance cycle. From then on, those strategies outpaced the market handily for years.

  Experience Is a Good Teacher

  My own experience, as well as that of many other contrarian money managers, is similar. Over the past thirty-five years, I’ve seen this same syndrome occur virtually every time contrarian stocks underperformed the market for any length of time. If you can live with the few bad periods and the odd terrible period, you should do very well. However, following through is much more difficult than it may appear. One last but very important Psychological Guideline:

  PSYCHOLOGICAL GUIDELINE 25: The investor psychology we’ve examined is both your biggest ally and your worst enemy. In order to win you have to stay with the game, but for many people that is difficult to impossible.