Contrarian Investment Strategies

The Psychological Edge

Book by David Dreman

Article and Review by GlobalMacroForex

David Dreman’s asset management firm manages over 5 billion and he owes his success to the principles laid out this book.  He points out how most mainstream investment strategies don’t work including CAPM, Efficient Market Hypothesis, Black-Scholes options pricing, and sell-side analyst predictions.  Instead he recommends investors adopt a contrarian mindset to take advantage of the market’s irrationality.

We’ll cover topics including:

·      Emotions in the Stock Market

·      Ignore Analysts

·      1987 market crash was emotions

·      Liquidity and leverage

·      Correlations being overrated

·      Importance of patience

·      How to be a contrarian

Let’s dig right in…

Emotions in the Stock Market

David Dreman cities a study by Professor Paul Slovic, a leading authority on cognitive psychology and Daniel Kahneman Nobel laureate in economics where he found, people use ‘Affect’ to make judgments.  The Affect is emotions acting on a person and that these emotions cause investors to make decisions that are not objective but instead colored by biases from their past.

“Images, marked by positive and negative affective feelings, guide judgment and decision making.”

Stocks or market sectors that burned us in the recent past we want to avoid, and those that gave us gains we want to repeat that.  This is the opposite of the contrarian investor.  Like politics where all the evidence in the world will just bring the person back to the same view, Mr. Dreman suggests investors aren’t fully analyzing the situation as it changes but instead just finding evidence to reaffirm their beliefs about the market.  They are looking for evidence that they are right.  Instead Mr. Dreman suggests we only go off the cold-hard math and security’s valuation numbers.

“Do not abandon the prices projected by careful security analysis, even if they are temporarily far removed from current market prices.  Over time the market prices will regress to levels similar to those originally projected.”

Mr. Dreman further goes on to cite a study by Robert Schiller, which found that the IPO price made no difference to a buyer of the IPO.  How investors got so caught up in the hype of the company’s potential, they forgot to analyze the valuation.

“If we have very strong feelings about the prospects of a stock or another investment, we will sometimes pay 100 times its real value or more.  This finding captures the major reason why stock prices are driven to astronomical heights during a bubble.”

He warns us not to be seduced by the recent rate of return.  Instead if it deviates sharply from what it normally is, it will likely revert back to the mean.

Ignore Analysts

David Dreman urges us to take what professional stock market analysts say with a grain of salt, if not outright ignore them.  They usually are being paid to promote the stock even though they don’t actually think it’s great.  He points out the cold hard math of even the best analysts are only right 50% of the time, making their predictions useless.

Pg 179 earnings estimates

Pg 191

In addition he in great detail goes over the scandals of sell-side analysts being paid at firms like Citigroup to tout stocks that they know are horrible, just for the IPO fees.

“Don’t be influenced by the short-term record or “great” market calls of a money manager, analyst, market timer, or economist, no matter how impressive they are; don’t accept cursory economic or investment news without significant substantiation.”

1987 Market Crash was Emotions

David Dreman argues the sudden stock market drop in 1987 was primarily emotions and not fundamentals.  He says in 1987 the P/E of the S&P500 dropped from 20 to 13.  13 is fairly priced so all the talk about it being “just like the Great Depression 1929 stock market crash” or similar comparisons of an oncoming bear market were overblown.  When in 1929 the P/E of stocks were through the stratosphere.  He warns against quickly drawing conclusions.

“Look beyond obvious similarities between a current investment situation and one that appears similar in the past.  Consider other important factors that may result in a markedly different outcome.”

Mr. Dreman argues the traditional investment theory of CAPM is flawed because risk is not just volatility.  He points out how in the 1987 crash, lack of liquidity and high margin leverage were the biggest risks.

Liquidity and Leverage

David Dreman disputes Efficient Market Hypothesis because he says it’s wrong in its core assumptions:

·     About liquidity

·     About leverage

·     About the correlation between volatility and returns

·     About volatility being stable over time

·     About rational investment “automatrons” always keeping prices right

He gives the example of Long Term Capital Management, a hedge fund that lost a massive amount of money in the 1990s, due to leverage and liquidity. He warns that leverage and liquidity are like hidden risks because they are not immediately obvious from the volatility track record.  He points out how liquidity decreases as stocks fall sharply.   This sharply increases the volatility of prices that wasn’t visible in the short-term record.  He points out how the opposite is also true, increasing liquidity normally occurs in rapidly rising markets.

Dreman warns the reader of trying to predict the volatility.

“Volatility in one period had little or no correlation with that in the next.  A stock could pass from violent fluctuation to lamblike docility.”

And he says this is the flaw of the Black-Scholes options pricing model, which assumes a stock’s volatility is consistent over time.  When in fact, he points out that they don’t say WHAT time period derivatives will revert to the mean.

He says instead of going off volatility as risk.  Instead go off of:

·     Company’s financial strength

·     Earnings power

·     Corporate leverage

·     Outstanding debt

Correlations are Overrated

David Dreman warns us about using too much information and drawing conclusions from it.

“Respect the difficulty of working with a mass of information.  Few of us can use it successfully.  In-depth information does not translate into in-depth profits.”

He says often investors see not what the data suggests, but what their preconceived notions, biases, and emotions tell them.  In this sense, using too much data turns it into a Rorschach test.  People think they found some predictor but correlation does not equal causation.

“The mind is probably designed to extract as much information as possible from whatever is available.”

The availability heuristic is a proven psychological bias people have to assume the likelihood of something is more likely as they have more exposure to it.  Mr. Dreman gives the example of study asking people if it’s more likely they will be killed in a car crash or hit with falling airplane parts.  The reality of the situation is that airplane parts are 30 times more likely than the shark.  But because many people are exposed to sharks from films like Jaws or other media outlets, they rank it as more likely.

“Don’t make an investment decision based on correlations.  All correlations in the market, whether real or illusory, will shift and soon disappear.”

Patience

Don’t expect that the strategy you adopt will prove to be an immediate success in the market.  He tells us we need to give it a reasonable time to work out.

 “Remember the advice of a world-champion chess player who was asked how to avoid making a bad move.  His answer: “Sit on your hands.”

Mr. Dreman gives us the cold hard truth that no strategy works consistently and we must develop patience.  Patience translates not only to making money but not loosing it by refusing to sell when the time comes.  We should instead be ready for the next opportunity.

“Don’t be stuborn, don’t be greedy, don’t be afraid to take small losses.  Above all, when you buy a stock, make a mental decision as to the level at which you will sell it-and stick to that decision.  You may lose a few points at the top, but in the long run you’ll make a lot more than you’ll lose.”

How to be a Contrarian.

David Dreman says the way to be a contrarian is to avoid analysts’ picks and instead buy value stocks that have a:

Low P/E

Low Price to cash flow

Low price to book

High Yield strategy

Low price to industry

While we want a cheap price, he warns us to never buy a company that is losing money.  Losses are an early-warning system that all is not well.

“The time to sell a stock is when it’s P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable its prospects may appear.  Replace it with another contrarian stock.”

David Dreman is a bear on Treasury bonds and bonds in general.  He say higher inflation and the tax structure favor equities.  The risk is not worth the reward on bonds.

Conclusion

Overall David Dreman tells us not to listen to the market hype, analyst recommendations, and our emotions.  Don’t follow CAPM or Efficient Market Hypothesis.  He tells us to focus on liquidity and leverage as risk factors, not volatility and correlation.  The key is to buy value stocks with low pricing valuations then sell them when they return to the overall market’s valuations.