by David Dreman
10. Jason Zweig, Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich (New York: Simon and Schuster, 2007), p. 66.
11. Ibid., p. 64.
12. Ibid.
13. Pammi V. S. Chandrasekhar, C. Monica Capra, Sara Moore, Charles Noussair, and Gregory S. Berns, “Neurobiological Regret and Rejoice Functions for Aversive Outcomes,” NeuroImage 39 (2008): 1472–1484.
14. Wolfram Schultz, Paul Apicella, Eugenio Scarnati, and Tomas Ljungberg, “Neuronal Activity in Monkey Ventral Striatum Related to the Expectation of Reward,” Journal of Neuroscience 12 (1992): 4595–4610.
15. Jason Zweig, “Your Money and Your Brain.”
16. W. Schultz and A. Dickinson, “Neuronal Coding of Prediction Errors,” Annual Review of Neuroscience 23 (2000): 473–500.
17. Chandrasekhar et al., “Neurobiological Regret and Rejoice Functions,” p. 1479.
18. Ibid. Though the fMRI has not yet been used on earnings surprise, dozens of similar tests have been done with parallel results in many areas, including finance, to investigate the neural correlates of regret and rejoice, disappointment and elation.
19. Zweig, “Your Money and Your Brain.”
20. Schultz and Dickinson, “Neuronal Coding of Prediction Errors.”
21. Chandrasekhar et al., “Neurobiological Regret and Rejoice Functions.”
CHAPTER 10: A POWERFUL CONTRARIAN APPROACH TO PROFITS
1. Francis Nicholson, “Price-Earnings Ratios in Relation to Investment Results,” Financial Analysts Journal 24, No. 1 (January–February 1968): 105–109.
2. Francis Nicholson, in an earlier test that eliminated companies with nominal earnings, measured the performance of high- and low-P/E stocks in the chemicals industry between 1937 and 1954. The results strongly favored the low-P/E stocks. James McWilliams used a sample of nine hundred stocks from the S&P Compustat tapes in the 1953–1964 period and found strong corroboration of the better performance of low-P/E stocks. McWilliams further discovered that although stocks having the highest individual appreciation in any given year appeared to be randomly distributed, those with the greatest declines were in the high-P/E group. William Breen used the 1,400 companies on the Compustat tapes for the 1953–1966 period. He eliminated all stocks with less than 10 percent earnings growth and then set up portfolios of ten stocks with the lowest P/Es relative to the market, comparing them with a series of randomly selected portfolios of ten stocks in each year. See Francis Nicholson, “Price/Earnings Ratios,” Financial Analysts Journal 16 (July–August 1960): 43–45; James D. McWilliams, “Prices and Price-Earnings Ratios,” Financial Analysts Journal 22 (May–June 1966): 137–142; William Breen, “Low Price/Earnings Ratios and Industry Relatives,” Financial Analysts Journal 24 (July–August 1968): 125–127.
3. See Table 7-3, “A Workable Investment Strategy,” in David Dreman, Contrarian Investment Strategies: The Next Generation (New York: Simon and Schuster, 1998), p. 147.
4. David Dreman, “A Strategy for All Seasons,” Forbes, July 14, 1986, p. 118.
5. David Dreman, “Getting Ready for the Rebound,” Forbes, July 23, 1990, p. 376.
6. We used the same methodology in all my studies, as is outlined in chapter 11.
7. David Dreman, “Cashing In,” Forbes, June 16, 1986, p. 184.
8. Within the experimental design, we adjusted for methodological criticisms of previous studies, such as hindsight bias—selecting stocks, as Nicholson did, that had survived to 1962, something an investor of 1937 could not have known—and not using year-end earnings and prices, as previous studies did, when investors could not know earnings until several months later. I did not think those would markedly change the results, and our findings indicate that they didn’t.
9. Sanjoy Basu, “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Markets Hypothesis,” Journal of Finance 32 (June 1977): 663–682; Sanjoy Basu, “The Effect of Earnings Yield on Assessments of the Association Between Annual Accounting Income Numbers and Security Prices,” Accounting Review 53 (July 1978): 599–625; Sanjoy Basu, “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks: Further Evidence,” Journal of Financial Economics 12 (June 1983): 129–156.
10. Basu, “Investment Performance of Common Stocks.”
11. B. Rosenberg, K. Reid, and R. Lanstein, “Persuasive Evidence of Market Inefficiency,” Journal of Portfolio Management 13 (1985): 9–17; Dennis Stattman, “Book Values and Stock Returns,” Chicago MBA: A Journal of Selected Papers 4 (1980): 25–45.
12. Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” Journal of Finance 47 (June 1992): 427–465.
13. Ray Ball, “Anomalies in Relationships Between Securities’ Yields and Yield-Surrogates,” Journal of Financial Economics 6 (1978): 103–126.
14. Fama and French, “The Cross-Section of Expected Stock Returns.”
15. Terence Pare, “The Solomon of Stocks Finds a Better Way to Pick Them,” Fortune, June 1, 1992, p. 23.
16. J. Lakonishok, A. Shleifer, and R. Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance 49 (December 1994): 1541–1578.
17. D. G. MacGregor, P. Slovic, D. Dreman, and M. Berry, “Imagery, Affect and Financial Judgment,” Decision Research Report 97-11 (Eugene, Ore., 1997).
CHAPTER 11: PROFITING FROM INVESTORS’ OVERREACTIONS
1. “Investors Lack Exposure to Contrarian Value Investing Strategies,” presentation given to David Dreman of Dreman Value Management, LLC, by DWS Scudder Deutsche Bank Group. Sources: Deutsche Asset Management, Inc., and Morningstar, Inc., 2006.
2. Sanjoy Basu, “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios,” Journal of Finance 32, No. 3 (June 1977): 663–682.
3. Werner F. M. De Bondt and Richard Thaler, “Does the Stock Market Overreact?” Journal of Finance (July 1985): 793–805.
4. The original investor overreaction hypothesis was updated in David Dreman and Michael Berry, “Overreaction, Underreaction and the Low P/E Effect,” Financial Analysts Journal (July–August 1995): 21–30.
5. David N. Dreman and Eric A. Lufkin. “Investor Overreaction: Evidence That Its Basis Is Psychological,” Journal of Psychology and Financial Markets 1, No. 1 (2000): 61–75.
6. For an overview of standard risk-return models, see Zvi Bodie, Alex Kane, and Alan Marcus, Investments, 9th ed. (New York: McGraw-Hill/Irwin, 2010).
7. The Compustat database comprises most of the major companies traded in this country, as well as some hundreds of ADRs traded abroad.
8. The methodology is identical to that in our study described in chapter 9, page 219.
9. Back in Graham’s time, investors used actual book value to price, whereas today most contemporary investors use relative book value, the book value of the company relative to its industry or the market. The reason is that with inflation increasing prices manyfold in the post–World War II period, the replacement costs of land, plant, and equipment are substantially higher than the values shown on most corporate balance sheets. The average company in the S&P 500 currently trades at 1.9 times its book value.
10. Although not shown in the chart, all three strategies continue to outperform for up to ten years. For those of a statistical bent, the t-tests are also high. For example, low P/E has only a 1 in 200 probability of being pure chance, low price to cash flow has 1 in 200, and price to book has 1 in 100. With the best stocks by each value measurement, the probability is 1 in 20. The t-tests are generally weaker on the high-P/E side, but 1 in 20 (the “95 percent confidence level”) is generally considered the basic threshold for significance.
11. Financial studies have indicated that well-diversified portfolios of as few as sixteen stocks have an excellent chance of replicating approximately 85 percent to 90 percent of the return of the group from which they are selected, even if the group is the stock market as a whole.
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12. The large-company rule is not etched in stone, however. As chap. 15 of Contrarian Investment Strategies: The Next Generation (1998) demonstrates, small contrarian companies provide somewhat higher returns over time than their larger siblings. But the small-cap strategy is entirely different and requires substantial resources to implement properly. It should normally be used for only a relatively small portion of your stock portfolio.
13. Andrew Ross Sorkin and Landon Thomas, Jr., “J.P. Morgan Acts to Buy Bear Stearns at Huge Discount,” The New York Times, March 16, 2008.
14. Robin Sidel, David Enrich, and Dan Fitzpatrick, “WaMu Is Seized, Sold Off to J.P. Morgan, in Largest Failure in U.S. Banking History,” The Wall Street Journal, September 26, 2008.
15. David Ellis and Jeanne Sahadi, “JPMorgan to Buy WaMu,” CNN Money, September 26, 2008.
16. See the performance of contrarian strategies including bear markets in chapter 10. In The New Contrarian Investment Strategy, I gave a similar record of performance from the 1976–1982 period, one of moderate market decline. The approach significantly outperformed the S&P 500 during that earlier period, too.
17. The results are taken from the twenty-seven-year study from 1970 to 1996 that I did in collaboration with Eric Lufkin, which I have updated through 2010.
18. Other studies over sixty years come up with similar results.
19. This is for one quarter. For one year, there would be twenty-five draws with the card returned to the deck.
20. The numbers are startling but true. To follow up, we did a Monte Carlo simulation with 100,000 trials. Low P/E won 99,891 times.
CHAPTER 12: CONTRARIAN STRATEGIES WITHIN INDUSTRIES
1. This work is based in part on an exchange of ideas between Sanjoy Basu and myself. Basu produced preliminary results that, unfortunately, were lost after his untimely death in 1983.
2. The previous literature on whether contrarian strategies worked included William Breen, “Low Price-Earnings Ratios and Industry Relatives,” Financial Analysts Journal (July–August, 1968): 125–127. Breen analyzed low-P/E stocks for one-year periods between 1953 and 1966. He found that stocks with low absolute P/E did only slightly better than stocks with the lowest P/E in an industry. However, the test used extremely small samples of ten stocks each. R. Fuller, L. Huberts, and M. Levinson, “Returns to E/P Strategies, Higgledy-Piggledy Growth, Analysts’ Forecast Errors, and Omitted Risk Factors,” Journal of Portfolio Management (Winter 1993): 13–24, found that low P/Es within industries outperform the market.
3. The original study by Eric Lufkin and me covered the period 1973–1996. We used a government industry classification system that was discontinued in the late 1990s. The industry taxonomy developed by Standard & Poor’s and Morgan Stanley Capital International called Global Industry Classification Standard (GICS) classifies industries more accurately for financial use. Reliable historical data for the newer classification start in 1995.
4. The industries that had the largest numbers of the absolutely cheapest stocks only marginally outperformed the averages, with returns well below those gained by the industry-relative strategy.
5. Benjamin Graham, David Dodd, Sidney Cottle, and Charles Tatham, Security Analysis, 4th ed. (New York: McGraw-Hill, 1962), p. 179.
6. Since I use large-cap companies in this strategy, the reader would be shielded from the frenetic small-cap concept stocks and IPOs, which were not a part of our study and which I doubt would come close to these results.
CHAPTER 13: INVESTING IN A NEW, ALIEN WORLD
1. Rob Iati, “The Real Story of Trading Software Espionage,” Advanced Trading, July 10, 2009. Online at http://www.advancedtrading.com/algorithms/218401501.
2. Kambiz Foroohar, “Trading Pennies into $7 Billion Drives High-Frequency’s Cowboys,” Bloomberg, October 6, 2010.
3. Jim McTague, “The Real Flash-Crash Culprits,” Barron’s, October 9, 2010. Online at http://online.barrons.com/article/58500042405.html.
4. “Preliminary Findings Regarding the Market Events of May 6, 2010—Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues—May 18, 2010,” p. 65.
5. Ibid.
6. Foroohar, “Trading Pennies into $7 Billion.”
7. Whitney Kisling, “Fund Outflows Top Lehman at $75 Billion,” Bloomberg, September 19, 2011.
8. Tom Lauricella, “Pivot Point: Investors Lose Faith in Stocks,” The Wall Street Journal, September 26, 2011.
9. Jenny Strasburg, “A Wild Ride to Profits,” The Wall Street Journal, August 16, 2011.
10. Nina Mehta, “High-Frequency Firms Tripled Trades Amid Rout, Wedbush Says,” Bloomberg, August 12, 2011.
11. CNBC, Fast Money, August 8, 2011.
12. Kevin Drawbaugh, “SEC Head Eyes Fast Traders on Crash Anniversary,” Reuters, May 6, 2011.
13. Jenny Strasburg and Jean Eaglesham, “Subpoenas Go Out to High-Speed Trade Firms,” The Wall Street Journal, August 8, 2011.
14. Mehta, “High-Frequency Firms Tripled Trades Amid Rout, Wedbush Says.”
15. Tim Cave, “European Regulator Moves to Limit High-Speed Trading,” Financial News, July 21, 2011.
16. Jacob Bunge and Brendan Conway, “Regulators Hone Circuit-Breaker Proposals,” The Wall Street Journal, September 28, 2011.
17. The record of these mutual funds can be found in the Forbes 2010 Mutual Fund Guide. Similar information on no-load funds can be found on Lipper, Morningstar, or Barron’s.
CHAPTER 14: TOWARD A BETTER THEORY OF RISK
1. Frank H. Knight, Risk, Uncertainty, and Profit, Hart, Schaffner, and Marx Prize Essays, No. 31 (Boston and New York: Houghton Mifflin, 1921):
Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. . . . The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. . . . It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We . . . accordingly restrict the term “uncertainty” to cases of the non-quantitative type.
2. Jeremy J. Siegel, Stocks for the Long Term (New York: Irwin), 1994.
3. FDIC, Trust Examination Manual, section 3, “Asset Management,” Part 1, “Investment, Principles, Policies and Products.”
4. Ibbotson® SBBT®, 2011 Classic Yearbook: Market Results for Stocks, Bonds, Bills and Inflation for 1926–2010. Growth of $100,000 for long-term government bonds adjusted for inflation from 1946 to 2010.
5. Tax Foundation, “Federal Individual Income Tax Rates History,” www.taxfoundation.org/files/fed_individual_rate_history-20110323.pdf.
6. An earlier version of this chart is found in David Dreman, Contrarian Investment Strategies: The Next Generation (New York: Simon and Schuster, 1998), p. 314.
CHAPTER 15: THEY’RE GAMBLING WITH YOUR MONEY
1. David Dreman, “Bailout Blues,” Forbes, Vol. 182, Issue 10, November 17, 2008, p. 136.
2. Frank Partnoy, “The Case Against Alan Greenspan,” Euromoney Institutional Investor, September 1, 2005, p. 2.
3. Lucette Lagnado, “After the Bubble, Beauty Is But Fleeting for Greenspan Portraits,” The Wall Street Journal, February 19, 2010.
4. Alex MacCallum, “Want Alan Greenspan to Come to Dinner? That’ll Be $250,000,” Huffington Post, March 28, 2008.
5. Partnoy, “The Case Against Alan Greenspan.”
6. “The Tragedy of Robert Rubin, the Fall of Citigroup, and the Financial Crisis—Continued,�
�� The Strange Death of Liberal America, November 30, 2008, http://thestrangedeathofliberalamerica.com/the-tragedy-of-robert-rubin-the-fall-of-citigroup-and-the-financial-crisis-continued.html.
7. Peter S. Goodman, “Taking a Hard Look at a Greenspan Legacy,” The New York Times, October 9, 2008.
8. Marshall Auerback, “Robert Rubin Is Back: Noooooo!!!” Business Insider, January 5, 2010.
9. Robert Scheer, “The Rubin Con Goes On,” The Nation, August 11, 2010.
10. Ibid.
11. Goodman, “Taking a Hard New Look at a Greenspan Legacy.”
12. Ibid.
13. Ibid.
14. Ibid.
15. Souphala Chomsisengphet and Anthony Pennington-Cross, “The Evolution of the Subprime Mortgage Market,” Federal Reserve Bank of St. Louis Review (January–February 2006): 38.
16. Board of Governors of the Federal Reserve System, “20-Year Treasury Constant Maturity Rate,” May 31, 2011, www.federalreserve.gov/releases/h15/current/h15.pdf.
17. “Residential MBS Insurance,” Inside MBS and ABS, LoanPerformance, Amherst Securities, 2010.
18. “Characteristics and Performance of Nonprime Mortgages” (Washington, D.C.: United States Government Accountability Office, July 28, 2009).
19. SEC Press Release, “Former Countrywide CEO Angelo Mozilo to Pay SEC’s Largest-Ever Financial Penalty Against a Public Company’s Senior Executive,” October 15, 2010, www.sec.gov/news/press/2010/2010-197.htm.
20. Peter Ryan and Kym Landers, “I Didn’t See the Subprime Crisis Coming: Greenspan,” ABC News, September 17, 2007.
21. I. P. Greg, James R. Hagert, and Jonathan Karp, “Housing Bust Fuels Blame Game,” The Wall Street Journal, February 27, 2008.
22. Jeremy W. Peters, “Fed Chief Addresses Foreclosures,” The New York Times, May 18, 2007.
23. “The Economic Outlook,” testimony by chairman Ben S. Bernanke before the Joint Economic Committee, U.S. Congress, March 28, 2009.
24. Ibid.
25. Guy Rolnik, interview with Nobel laureate Daniel Kahneman, “Irrational Everything,” Haaretz, April 10, 2009.