Contrarian Strategies

Contrarian strategies In a great book, well worth reading “The Winners Circle”, the author, R J Shook, writes on David Dreman. “The New York Times calls him the “Grand Master.” Barron’s calls him a “Pro.” On Wall Street he is known as the “King of Contrarians.” The Winner’s Circle ranks him as the best large-cap value fund manager anywhere. With nearly three decades’ worth of successful investing to his credit, David Dreman’s name has become synonymous with contrarian investing. Over the last decade alone his Scudder-Dreman High Return Equity Fund has clobbered its benchmark S&P 500 by almost three percentage points—and his average peer by almost four percentage points—through December 2003 with a return of 13.71 percent. While countless others have tried to emulate his strategy, he remains inimitable, consistently besting competitors with his long-proven strategy. Spending the better part of an afternoon interviewing David in his office, I was impressed beyond my highest expectations. Beside his extraordinary investing accomplishments, David has high academic qualifications, and is a well-regarded author and a regularForbes magazine contributor. Soft-spoken, humorous, and charismatic, he is always willing to offer his knowledge to large or small investors. Delving into the mind of one of our era’s greatest investors, I was able to uncover the ideologies and principles behind his brilliant strategy. Background and Education To best understand David, I found, one must go back to his early life in < ?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Winnipeg, Canada. Born in 1936 into a tightly knit family, David had a normal Canadian childhood—lots of ice hockey, skating, and skiing— with one exception: Beginning at age three, he spent a good portion of his youth on the Winnipeg Commodities trading floor, the biggest of its kind in Canada. His father, with whom he had a close relationship, traded in the pits and regularly brought his young son to work. Some of David’s earliest memories are of the activity and buzz of the trading floor. As he grew older, he marveled at his father’s trading ability. Even though his father traded against the crowd, he was consistently very successful, considered one of the best. In fact, the Canadian Exchange established an award in memory of his commitment to the highest level of ethics and success in trading. David didn’t realize it at the time, of course, but he was receiving from his father perhaps the first-ever formal training in contrarian investing. As busy as his father was trading, he took the time to explain to young David exactly which decisions proved right and which proved wrong. Thus, as a teenager, David could tell you that large investors, even the brokerage houses, tended to follow the current trends, and why that proved wrong more often than right. www.capitalideasonline.com Page - 1 Contrarian strategies By the time he entered the University of Manitoba he considered himself a contrarian in economics and a contrarian in investment theory. “Before you can consider yourself a contrarian today, you must be formally schooled,” David says, perhaps thinking back to his decade-and-a-half of experience in the trenches before he left home for college.” I was schooled in the traditional way, but I always questioned the traditional methods.” In particular, he always had reservations about certain evaluation techniques used by analysts. The basic tenet of the contrarian philosophy is that investors are driven by irrationalities, which leads to anomalies in the market. This opposes the widely acceptedefficient market theory that (1) investors act rationally, and (2) all information is immediately factored in the prices of stocks so that it is not possible to beat the market consistently. Behavioral finance, a philosophy related to contrarian investing, is the study of the financial markets that integrates psychology and economics. (In 2002 the Noble Prize in Economics was awarded for the first time in this field.) Contrarian Research Beginnings David graduated with a major in business and an MBA in finance (he later received an honorary doctorate from the university), and promised himself one year on Wall Street in order to carefully study the markets before heading back to Manitoba. “The U.S. markets have always been far more volatile than the Canadian markets,” he says, “so I felt Wall Street was the right setting to study market behavior.” Hired as an analyst by Value Line in the mid-1960s, he was given $15,000 a year to pick stocks. His hard work and ability to spot value in the marketplace won him a spot picking stocks for a growth mutual fund. While he proved successful, he felt that he had not yet mastered his contrarian philosophy, and so he left the fund to do his own research. This research led to his first book,Psychology and the Stock Market: Investment Strategy Beyond Random Walk (Amacom, 1977). At this point, David knew that New York—the financial capital of the world— was where he belonged. His two-year research hiatus began after the bear markets of 1973 and 1974. As stocks became overvalued during the late sixties and into the early seventies, David wondered why Wall Street was so enthusiastic about them. Then the bear markets hit; those same stocks were 90 percent cheaper, and no one wanted to touch them. With hard assets selling at a fraction of their breakup value, David was determined to figure out why investors avoided stocks like the plague, whereas he saw only value. www.capitalideasonline.com Page - 2 Contrarian strategies “This behavioral finance fascinated me,” David begins, as he discusses his groundbreaking book, one of the first to broach the subject of behavioral finance. “It was really about why people consistently make mistakes. These analysts and money managers are extremely bright individuals, but I identified some real reasons why they tend to follow the crowd. For example, why do they tend to throw away their formal training to pursue mistakes, which they later regret and agree never to do again? My first book enabled me to thoroughly explore and research these events that I was witnessing,” David says, looking back to the contrarian training he had been receiving since early childhood. “I just felt that with all these warnings there had to be a better way to invest.” David was initially reluctant to publish the book, given that the facts he had discovered did not paint a pretty picture of Wall Street professionals. “I thought I might be alienated from Wall Street,” he says with a short laugh. However, David’s book was extremely well received. In fact, many money managers called him, praising him for his insights and asking him for advice. In 1977, shortly after the book was published, David was asked to lead the research efforts at a Wall Street .rm. Later, he was asked to manage money by institutional investors, and started his own company—a predecessor to Dreman Value Management, which now manages the Scudder- Dreman High Return Equity Fund. Since its beginning, the money management company has been based entirely on the contrarian investing principles set forth in his books. Although David had money waiting in line to be invested with him, he still felt the pains of starting a new business. “I really had to focus on building a team that could support my investing processes, and enable me to spend my time doing what I do best—managing money.” Meanwhile, he was working nights and weekends to expand the research of the first book by adding specific landmark contrarian strategies, such as investing in out-of-favor stocks, which he found outperformed their in- favor counterparts. These new discoveries were published in his 1980 book,Contrarian Investment Strategy (published by Dreman Contrarian Group). “My first book covered the psychological aspects of markets and the influence of psychology on investing,” he says. “Regardless of their formal training in finance or their financial backgrounds, people tend to make the same psychological mistakes over and over Contrarianagain.” Investment Strategy covers many of the mistakes that most investors tend to make, while focusing on the contrarian methods that David has developed in great detail. The book was hailed as groundbreaking by the New York Times and major Wall Street firms. Contrarian Strategy at Work www.capitalideasonline.com Page - 3 Contrarian strategies Contrarian Investment Strategy generated so much positive publicity that not only were the money managers calling him for advice, but investors called him, asking him to manage their money. “I never realized that my research would ever lead to money management,” he says, still startled by the evolution of his career. After five years, David had a solid track record, outperforming both the S&P 500 and his average peer. An avalanche of new money owed into his firm. His clients consisted of both institutional and high-net worth accounts. By 1985, value stocks had posted impressive returns versus other sectors, mainly growth stocks, for several years. Investors started believing that value had seen its day and would never come back; consequently, value stocks dropped in price, enabling David to buy more of them. A year or so later, value stocks came back, positioning David’s investors with big gains. By this time, David had made a name for himself and his firm and had fine-tuned his investment philosophy. “We’re really value investors,” he says.” We buy stocks when they’re priced low to earnings, priced low to cash flow, priced low to book value, and we prefer to buy these stocks if they provide an attractive yield.

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