While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most - if not all - of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them - and their clients or shareholders - very happy.
But while most of the gurus upon whom my "Guru Strategies" are based are contrarians, one stands out among all the others: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very, very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.
Currently, the investment model I base on Dreman's approach is available through the Guru Analysis & Guru Stock Screener App in Seeking Alpha's Investing App Store. It's an approach that has fared quite well for me: Since its July 2003 inception, a 10-stock portfolio picked using the model has gained 78.5%, or 8.2% annualized. During the same period, the S&P 500 has returned a total of 18.%, or just 2.3% per year. This year, the Dreman-based portfolio is nearly tripling the index's gains (15.9% vs. 5.9%).
Finding Winners Among the Market's Unloved
Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in such beaten-up stocks as Altria (NYSE:MO) (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (NYSE:TYC) (which had been hit hard by an embarrassing CEO fiasco).
How - and why - did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks - those "hot" stocks everyone seems to be buying - and undervalue the "worst" stocks - those that people are avoiding like the plague, such as Altria and Tyco. In addition, he believed that the market was driven largely by how investors reacted to "surprises," frequent events that include earnings reports that exceed or fall short of expectations, government actions or news about new products. And he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.
When you put those factors together, you get the crux of Dreman's contrarian philosophy. Surprises happen often, and because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to gain. By targeting out-of-favor stocks and avoiding in-favor stocks, Dreman found you could make a killing.
Specifically, Dreman compared a stock's price to four fundamentals: Earnings, cash flow, book value and dividend yield. If a stock's price/earnings, price/cash flow, price/book value or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't giving it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)
But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted were good companies that were being undeservedly ignored, often because of apathy or overblown fears about the stock or its industry. To find them, he used a variety of fundamental tests, including return on equity, the current ratio, debt/equity ratio and pre-tax profit margins. He also keyed on stocks that were offering a high dividend yield while having payout ratios (that is, the percentage of profits paid out as dividends) that were the same or less than their historical average.
This type of contrarian approach isn't for the faint-of-heart. You never know exactly when investors will wake up to a bargain they've been overlooking. But if you're patient, these types of beaten-down hidden gems can pay off big-time. Here are a handful of stocks my Dreman-inspired approach thinks are worth a look right now.
AT&T Inc. (NYSE:T): The Dallas-based telecom giant ($166 billion market cap) comes from a sector that has been ignored in recent years. Telecoms have averaged returns of -2.9% during the past three years, according to Morningstar.com, making them one of the market's four worst performers.
Partly because of the general lack of love for telecoms, AT&T's P/E, price/cash flow and price/dividend ratios all fall into the market's bottom 20%. But my Dreman-based model, which gives the stock a 91% score, likes the firm's 19.8% return on equity, pre-tax margins of more than 17% and debt/equity ratio (61%), which is significantly lower than its industry average (85%). It also has a 6% dividend yield, while paying out a much lower portion of profits as dividends (47%) than it has historically (78%). That's a sign the firm may be able to increase its payout.
Exelon Corporation (NYSE:EXC): Based in Chicago, this electric and natural gas utility ($26 billion market cap) also comes from an overlooked sector, and earns a 90% score from the Dreman approach. Its price/cash flow and price/dividend ratios are both in the market's bottom 20%, despite its solid 1.7 current ratio (vs. its industry average of 1.15); its return on equity of almost 20%; and its pre-tax profit margins of 23.5%. Exelon also is yielding 5.3% while paying out a lower portion of profits (53%) than it has historically (65%).
BBVA Banco Frances S.A. (NYSE:BFR): While financial firms have fared well since the March 2009 low, there's still a good deal of fear hovering over the sector. My Dreman-based model thinks investors would be wise to look past their fears and take a look at this Argentina-based bank, which it gives a 90% score. The $2.1-billion-market-cap firm's P/E and price/dividend ratios are both in the market's bottom 20%, yet it has an excellent 50.6% return on equity and pre-tax profit margins of more than 32%.
East West Bancorp, Inc. (NASDAQ:EWBC): Based in Pasadena, Calif., this regional bank (which also gets a 90% score from the Dreman model) was hammered during the financial crisis. It has rebounded nicely since the market turned in 2009, but my Dreman-based model thinks investors still aren't giving it its due. The $2.5-billion-market-cap firm has been increasing earnings recently ($0.27 in EPS in the most recent quarter, vs. $0.20 in the previous quarter), and it's posting a strong return on equity (21.6%) and impressive pre-tax profit margins of 43%. Yet the stock still is in the bottom 20% of the market in terms of P/E and price/cash flow ratios, making it the sort of contrarian play this model likes.
Telefonica S.A. (NYSE:TEF): This Spain-based telecom giant ($105 billion market cap) has major operations in both Europe and Latin America, and gets a solid 84% score from my Dreman-based approach. The stock is in the bottom 20% of the market in terms of P/E, price/cash flow and price/dividend ratios. But it has a return on equity of more than 55%, pre-tax profit margins of 23.8% and a dividend yield of 7.8%, all of which earn high marks from the Dreman model. One point of caution: While telecoms tend to carry a lot of debt, Telefonica's debt/equity ratio is particularly high (273%).