Some notes on Contrarian Investment Strategies by David Dreman

Contrarian Investment Strategies (book cover)

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.

Book summary: ‘The big secret for the small investor’ by Joel Greenblatt

Chapter 1: How to beat the market

The Efficient Market Hypothesis (EMH) which says that markets are efficient, and therefore it is not possible to beat the market, other than by luck, is false. Still, beating the market can be very difficult, even for highly intelligent, hard working people who have attended top business schools. The secret to beating the market is in learning just a few simple concepts that almost anyone can master, and that serve as a road map. Even though the concepts needed to be a successful stock market investor are simple and most people can do it, it’s just that most people won’t.

Chapter 2: The secret to succesful investing

The secret to successful investing is to figure out the value of something and then pay a lot less. The ‘a lot less’-part is called the margin of safety. The value of a business comes from how much that business can earn over its entire lifetime (20-30 years). (Actually it is better to use cash flow instead of earning, but in the book it is assumed that earnings are a good approximation for cash received.) The earnings need to be discounted to the present, which is called a Discounted Cash flow analysis (DCF) to get the Present Value (PV). The problem with a DCF is that 1) it is almost impossible to predict earnings for the next 30 years and 2) small changes in growth rates and discount rates end up making a huge difference in the present value.

Chapter 3: Other valuation methods

Besides a DCF, there are also other ways to determine the value of something. For instance, you can use a relative value, acquisition value or liquidation value analysis. For larger companies with multiple divisions, you can use a different analysis for each division, and then combine the values of the divisions to get a sum-of-the-parts value. But each of these valuation methods has its own drawbacks and difficulties. So the main point is that it is not so easy to figure out the value of a company. And if we can’t determine the value of a company, we can’t determine an amount that we’d be willing to pay where we’d have a margin of safety.

Chapter 4: Capital allocation

An important part of investing is capital allocation: you compare different investment possibilities to find that ones that are most attractive, that is which you think will provide the best risk-adjusted returns. The first hurdle an investment in a stock must pass, is an investment in a 10-year US government bond, for which we assume the interest is at least 6%. The interest rate on a 10-year US government bond, we call the risk-free rate. If the earnings yield (earnings/price) of a stock is much higher than the risk-free rate, then it might be a good investment depending on how certain we are of our estimates of future earnings of the company. If the first hurdle is passed, we can compare the attractiveness of investing on stock A to different stocks. If we can’t make an estimate of future earnings of a company, we just skip that investment.

Chapter 5: Ways in which individual investors can beat the market

If you’d want to beat Tiger Woods, it would be best to choose a different game than golf. If you’d want to beat professional money managers in investing, it is better to choose a style of investing where they can’t or won’t compete with you. Some possibilities are investing in small capitalization companies (small caps), focused investing (where you analyze and invest in just a few companies where you have a special insight or some deeper knowledge) and special situations investing (spinoffs, bankrupties, restructurings, etc.) The drawbacks of investing in special situations, is that they still require a reasonable amount of work and you still need to have some valuation skills.

Chapter 6: Mutual funds

If you don’t want to do your investing yourself, you can invest in mutual funds. Mutual funds come in two flavors: active and passive. In an active mutual fund an manager tries to invest in a basket of stocks that will beat the market. In a passive mutual fund (also called an index fund) the approach is to try to replicate the returns of an index such as the S&P 500 by buying all or most of the stocks in that index. This chapter focuses on active mutual funds. Managers of mutual funds earn money through the fees paid by investors: the more money they manage, the more they generally earn. So managers of mutual funds try to get investors to invest as much money as possible with them, but this effectively excludes them from investing in small caps (especially focused investing in small caps). Focused investing in large caps is still possible, and though this has the chance to outperform the benchmark, it also has the chance to underperform the benchmark for long periods of time. And since investors in mutual funds usually don’t have a lot of patience, they flee the mutual fund before it has the chance to outperform. Since this is not what the managers want, they will generally not invest in a focused way. Investing in special situation is also no option for mutual funds due to a variety of reasons.

Conclusion: some of the most effective ways to beat the market (as explained in chapter 5), can’t or won’t be used by mutual fund managers. Therefore, most mutual funds don’t beat the market, and because of fees, they don’t even match the market. Although there are some superstar managers who manage to beat the market over longer periods of time, 1) it is difficult to finds these managers ahead of time and 2) most investors time their investments in the fund poorly: they come in after the fund has performed well and they leave after the fund has performed poorly, thereby realizing a much worse return than if they had stayed with the fund for a long period of time.

Chapter 7: Index funds

As we’ve seen above, it’s almost impossible for most investors to value companies on their own, and hiring experts (active mutual fund managers) also doesn’t work because most funds underperform the market and it’s very difficult to find that funds that will outperform the market ahead of time. A good alternative is to buy an index fund, like a fund which tracks the S&P 500 index. The advantage is that can be implemented very cost-effectively and efficiently. The problem is that investing this way is fundamentally flawed: since the index is market-cap weighted (the larger the market capitalization of a company, the larger the part of that company in the index), the more overvalued a company is the more overweighted it becomes (and vice-versa). So you end up systematically owning too much of the companies that are overvalued and systematically too little of the companies that are undervalued.

A better alternative to market-cap weighted indexes are equally weighted indexes in which each company has the same weighting. This adds on average 1-2% of return per year over market-cap weighted indexes. The problem with equal weighting is that these indexes can’t handle too much money due to the smaller constituents in the index. Another alternative is fundamentally weighted indexes, where the weighting of a company in an index is determined on the basis of one or more fundamentals like earnings, sales, dividends, book value, etc. This also adds on average 1-2% of return per year, and –unlike equal weighted indexes– it can handle large amounts of money, since larger cap companies are still overweight in the index, and also requires much less trading within the fund. So fundamentally based indexes are a better way to replace market cap weighted indexes than are equally weighted indexes.

Chapter 8: Value-weighted index funds

An attempt to improve upon fundamentally based indexes, is to use the value effect: companies that appear cheap relative to earnings, book value, etc. have been shown to beat the major market indexes by as much as 2-3% per year over long periods of time. So we could design a value-weighted index in which the cheaper a company appears, the larger its weight in the index. And while we are at it, why don’t we add the philosophy of Warren Buffett and Charles Munger to the mix, and look for companies that are not just cheap, but cheap and also good. Trailing earnings yield (the earnings yields based on last fiscal year’s financial data) can be used as a proxy for cheapness and trailing return on capital as a proxy for quality (see ‘The little book that still beats the market’, also by Joel Greenblatt). Had you done this over the last 20 years, you would have beaten the S&P 500 by about 6% annualized (trading costs and market impact modeled, but fund fees not included). When you use a value-weighted index, you not only remove the systematic error that is present in a market-cap weighted index, but you also add to the performance by buying more of stocks when they are available at bargain prices.

Chapter 9: Staying the course

The first part of the big secret for the small investor, is to have the right strategy, which is to invest in companies that are both cheap and good. The second part is that we need to stick to the strategy over long periods of time. This is very difficult for many investors to do, because –as research on the subject of behavioral finance has shown– most investors are practically hardwired from birth to be lousy investors: among other things they are impatient, loss-averse, have a herd mentality, are focused on recent events and are overconfident. As we have already seen above, value investing strategies can underperform the market for periods of multiple years. For very good investors this is a blessing in disguise: if a strategy would work every week, every month and every year, everyone would be a value investor and eventually the strategy would stop working, because in that case the market would be truly efficient. For all other investors, long periods of underperformance are a curse, because they will be tempted to abandon their strategy much too soo and probably at precisely the wrong time.

To help us deal with our human flaws in the area of investing, we need a policy in which we first define what part of our portfolio should be allocated to equities, and then how much that part may vary over time. After we have done that, we need to stick to our policy.

When we combine the strategy and the policy, we have The big secret for the small investor: a new route to long-term investment success.

Summary of Gurufocus research on Buffett-Munger style investing

Investors are always looking for a system to achieve higher returns with less risk. How to find such a system? Why not start by looking at what one of the world’s greatests investors, Warren Buffett has been doing for many years? Buffett has said many times that he likes to buy companies with the following characteristics:

  1. Simple businesses that he understands
  2. that have predictable and proven earnings
  3. with economic moat
  4. which can be bought at reasonable prices.

The people at Gurufocus have tried to convert the last 3 characteristics in rules for investing, thus creating a system. They also conducted a back test study of parts of their system and also the system as a whole over the period between 1998 and 2008. In this post, I will give a summary of their publication. The original articles can be found here:


Buffett-Munger style investing means buying stocks of great companies at good prices. (Actually Buffett also invests in different ways, like buying companies outright, but this is not possible for the average investor. Also he invests in other securities like bonds, but this is not the focus of this post.) Good companies will continue to increase their earnings per share in the future and the stock value will eventually increase to reflect the growing earnings (in the long the stock market is a weighing machine). If the stock can be bought at good prices, you have now found a good investment. We are searching for a system to help us find Buffett-Munger type investments. The system should work in all markets to help us find investment which have a high potential return while simultaneously having a low risk for permanent loss of capital. That is, it should follow Buffett’s rule number 1: ‘Never lose money’. The 2008/2009 recession is a great period to test the system, since if the system contains fundamental flaws, these will probably be exposed in this crisis.

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