Just finished reading Contrarian Investment Strategies: The Classic Edition by David Dreman.
My impression of Dreman before reading the book wasn’t very good: I saw some of his TV interviews and was very unimpressed. Also I remember some of his fund’s holdings coming into the financial crisis absolutely got killed.
But I realized that the impression a person makes in the media need not have any relation to his knowledge and skill, and I read some positive reviews on his books in multiple places, so I decided to give it a try. The desire to read the book was also strengthened by my interest in quantitative investment strategies.
Having read the book, I must say I’m quite impressed. Dreman really knows what he’s talking about, having invested himself for many decades, and also having performed good scientific research.
I had expected that the book would be mostly about quantitative investing, but it discusses many more subjects. For instance it explains clearly what is wrong with technical investing and the Efficient Market Hypothesis (EMH). It also has a whole section on behavioral investing, which is quite good, and also goes into the subject of how to define risk and what would be the main risk investor face today. (I skipped many of the sections on technical investing and EMH, because nobody has to convince me what’s wrong with them.)
The best part of the book are the sections on quantitative investing. Most important conclusions of this part:
- Buying a basket of low P/E, low P/CF, low P/B or high dividend yield, results in very significant market beating returns over time: something in the order of 3% per year. “What investors really get paid for, is holding dogs.”
- You don’t have to turn over the portfolio a lot: if you buy a basket of low P/E stocks for instance and hold them for multiple years, let’s say up to 8 years, then your return doesn’t decay much with respect to rebalancing the portfolio every year. This saves a lot of transaction costs (transaction fees and bid-ask spreads) and taxes.
(Note: the last point conflicts with some other results I’ve seen, see for instance the website Validea and StockScreen123, which show that higher rebalancing frequencies lead to higher annualized returns before taxes and transaction costs.)
A critique of the book, especially for an investor who already knows a lot about value investing, is that the book is long (it has 450 pages). A person only interested in quantitative value investing could find 90% of the information in Dreman’s book in the excellent article What has worked in investing by Tweedy, Browne Company.
Many good articles on quantitative value investing can be found on the blogs Greenbackd, Fat Pitch Financials and Magic Diligence. And of course, you should read The little book that still beats the market and The big secret for the small investor (see my summary here). Both book are very good and short reads, and both have been written by legendary investor Joel Greenblatt. But I digress…
Back to Dreman’s book. As said, the book is quite long, but many subjects are covered in depth, and I learned some things that I didn’t know before, and also got some good ideas. Some of the main points:
- A good sell discipline is one of the hardest things to develop.
- Contrarian stocks can move substantially higher in price and still be good holdings.
- When companies keep their dividend high during a crisis, it is an important indicator that management think the company is not in big trouble, or else they would have reduced the dividend or cut it completely.
Note: Of course management could also abuse this signal, keeping dividends high to give the impression that the company is allright, even though they know it is in deep trouble, and at the same exacerbating the trouble by not reducing the dividend.
- You can apply a contrarian approach within industries. Instead of just buying the very cheapest stocks you can find, you can buy the cheapest stocks in each industry. Why would you do this? It prevents industry concentration, leading to lower risk and making investing less psychologically taxing.
- If you buy good companies who are temporarily in trouble, you can get a double whammy: multiples increases on earnings per share which also increase.
- If you don’t rely on a purely mechanical strategy, then how long should you hold a stock that has not worked out? Six years, according to John Templeton.
- Patience is a crucial but rare investment commodity.
- The symptoms of all manias are remarkably similar.
- If a good company’s stock falls sharply due to a negative surprise making it undervalued, should you buy immediately or should you wait a little bit? It’s a tough call, but it seems it is a good idea to let the dust clear. “Don’t be a hero and charge into the initial panic. If you like a stock blown out by disappointing news, it pays to sit on the sidelines for a while. In all probability, you will get plenty of chances to buy it cheaper in the next 90 days.
When there is a negative surprise, the poorer results, even for first-rate companies, are likely to continue for a while. It takes time to ride through an unanticipated rough stretch. As a result, the initial sock is often followed by later, if lesser shocks, which continue to put pressure on the price.”
Note: If Dreman is right on this, then this quote alone is more than worth the time to read the whole book, since value investor are almost always way too early.
- The investor overreaction hypothesis: investors overreact to events in a predictable fashion: they consistently overvalue to prospects of “best” investments and undervalue those of the “worst”.
- Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. This leads to Rule 27: The push toward an average rate of return is a fundamental principle of competitive markets (reversion to the mean). Warren Buffett may be right that you should look for companies that have a moat, but it is very rare that these moats are sustainable over large periods of time. Also, for many investors whose name is not Warren Buffett, it is difficult to assess whether there is really a moat and even more whether the moat is sustainable. As Dreman writes: “It is true, of course, that there are excellent companies that will continue to chalk up above-average growth for years or decades to come, and there are especially talented investors who will find them at reasonable prices. But for most of us, whether individual or expert, the odds of winning at this game are pretty slim.”
- In crisis, most people do not make objective evaluations.
- Investing during crises is psychologically taxing, even for the very best investors. Mentally you know that this is a great time to sow the seeds of great future returns by buying when prices are low, but at that moment the future looks so bleak and you start to doubt whether this time may actually be different. Quantitative investing is simple but not easy. None of us can escape the anxiety and doubt that permeates a crisis.
- Some people, e.g. airline and combat pilots, are taught how to cope with crisis, because crises can be deadly if not handled properly. It would be an excellent idea to train investors how to deal with crises, for instance by using simulations.
- Banks have been a low P/E industry for years. Pharmaceuticals are normally a high multiple industry.
- “If you get a combination of a panicky market and an industry or sector panic, such as occurred with financial stocks, the potential rewards are that much higher.”
- Between 1802 and 1996, stocks increased on average by 7% annually after inflation, but before taxes.
- Risk is definitely not the same as volatility. It is not even the possibility of loss of principal, but it is possibility of the loss of purchasing power. While it is very hard to define risk accurately, if you have a diversified basket of stocks, then the price-to-value (P/E, P/B, etc.) can be a very good proxy of the risk: the lower this ratio, the lower to risk.
- Investing in small-cap companies has some drawbacks, even for investors with relatively low assets, like sometimes much higher spreads, sometimes exceptionally low liquidity, and a larger risk of accounting gimmickry. “With the smaller issues, you must be prepared to buy them and hold them or the turnover costs will eat you up.”
- Also, small cap investing tends to be much more volatile and small caps can have a disconnect to the market for a number of years. But, when small caps click, gains can be enormous.
- History shows that group madness is not necessarily short-lived.
- All the market anomalies have one common denominator: investor psychology.
- Investing can be a probability game with the odds on your side.
If you are a relatively inexperienced investor and want to know whether you should do technical investing, index investing, value or growth investing, focused or diversified investing, fundamental or quantitative investing, small cap vs. large cap investing, portfolio management, and many other subjects, read this book cover to cover! You will also get a very good summary of behavioral investing at the same time.
If you are mainly interested in quantitative investing, then first read the article by Tweedy, Browne Company and the two books by Joel Greenblatt I mentioned. Then, if you still want more, you can read this book. You may may want to skip some sections and skim some other sections, though. Still, there is a lot of valuable information in this book. David Dreman did a great job, and I’m happy to have read the book.
If you are more interested in the Warren Buffett style of focused investing in great companies at good prices, this is not the right book for you.