In a recent interview with the Columbia University investment newsletter Graham & Doddsville, adjunct finance professor Michael Mauboussin said, "If you distinguish the great investors from the average investors, it's not because their cost of capital calculation is more accurate. It almost always has to do with the fact that they're able to make good decisions and be correctly contrarian in adversity." He later quips, "Being contrarian for the sake of being a contrarian is a bad idea."
Put another way, choosing unpopular stocks to invest in doesn't ensure you'll make money, but using solid, fundamental analysis as part of your decision-making process can help you be "correctly" contrarian.
In his book Contrarian Investment Strategies: The Next Generation (1998), famed contrarian investor and longtime Forbes columnist David Dreman delves into investor psychology and outlines a deep value, contrarian investment methodology for stock selection. The problem, says Dreman, is that investors get in their own way by overreacting—a tendency that the contrarian investor can exploit, earning hefty returns in the process. For example, investors overprice "hot" stocks and consistently underprice those that trigger doom-and-gloom media attention due to price dips. Dreman argues that popular stocks with stretched valuations have a long way to fall if they don't meet expectations and little room to climb in the event they meet or exceed expectations. For instance, Facebook's (NASDAQ:FB) 18% decline yesterday after its earnings call is a good example of a hot stock that missed. You can see 20% wiped of shareholder value wiped out in a signal trading session.
The converse is true for unpopular stocks—which have a lot of headroom and less downside risk. By going against the herd mentality, Dreman argues, the smart contrarian investor had the chance to beat the market by focusing on stocks that are priced lowest (specifically, in the lowest 20% of the market) in relation to such fundamentals as price-earnings, price-cash flow, price-book and price-dividend ratios. Dreman goes further in his analysis than bottom-feeding on price-based measures, however. To ensure that a company is fundamentally and financially sound, he uses metrics such as return-on-equity, profit margin, and debt-equity ratio in his analysis.
Contrarian investing capitalizes on the emotional, knee-jerk reactions that make unpopular stocks underpriced so an investor is poised to benefit from upside should a business meet or exceed expectations.
The Dreman Methodology
Dreman identified these undervalued companies by comparing their stock's price to four different financial variables that gauged the strength of the underlying business; earnings, cash flow, book value, and dividend yield. He conducted studies from 1970 to 1996 in which he examined returns of stocks in the bottom 20 percent of the market according to price-earnings, price-cash flow, price-book and price-dividend ratios. The average annual returns corresponding to those stocks with the lowest ratios were:
- Price-earnings: 19%
- Price-cash flow: 18%
- Price-book: 18.8%
- Price-dividend: 16.1%
All of these exceeded the returns of the greater market during that period (15.1%), while exposing the investor to less risk.
Using Dreman's philosophy as a foundation, I created a stock screening model to identify fundamentally sound, undervalued companies. The first test a stock must pass to be favored by this model is that it falls in the bottom 20 percent of the market for at least two of the below four ratios. At the current levels, that means a stock would have to have valuation ratios below the figures below.
- Price-earnings below 12.23
- Price-cash flow below 7.14
- Price-book below 1.13
- Price-dividend below 20.0
Once that is achieved, the stock must meet the following additional benchmarks:
- Market capitalization: Dreman believed that larger firms are more in the public eye and therefore tend to have more staying power and are less prone to using accounting gimmickry. So, our Dreman-based model requires that the company's market capitalization (share price times shares outstanding) must be among the 1,500 largest companies in the market.
- Earnings trend: Dreman liked to see a rising trend in earnings, so our model requires earnings in the most recent quarter to exceed those of the prior quarter.
Note: For non-cyclical companies only, Dreman preferred earnings growth to exceed that of the S&P 500, so he examined EPS for the past six months. He also evaluated the likelihood that earnings would remain stable in the near future. Our Dreman-based model, therefore, requires EPS growth over the past six months as well as estimated growth for the current year to be greater than the same figures, respectively, for the S&P 500.
The following Dreman-based criteria are used to differentiate between those stocks that are beaten down because of irrational fear and those suffering from long-term financial problems in the underlying business:
- Current ratio: This metric shows the level of current assets relative to current liabilities and was viewed by Dreman as in indicator of a company's ability to pay off its current debts. To pass our Dreman-based stock screen, therefore, a company must have a current ratio that is either higher than 2.0 or higher than the industry average. AMC Networks (NASDAQ:AMCX) and H&R Block Inc. (NYSE:HRB) meet this test with current ratios of 2.64 and 2.24, respectively.
- Payout ratio: Dreman found that if the percentage of earnings a company pays out in dividends is less than the stock's 5- to 10- year historical average, there is plenty of room to raise the dividend going forward. Our model targets those firms whose current payout ratios are lower, on average, than in the past. Blackstone Group LP (NYSE:BX) and Santander Consumer USA Holdings Inc. (NYSE:SC) both meet this requirement.
- Return-on-equity: This is an important way to measure how profitable a company is, and Dreman believed that a solid ROE ensured against structural flaws in the company's operations. He required ROE to be greater than that of the top one-third of the 1,500 largest-cap stocks (and considered anything over 27 percent to be outstanding). To pass our screen, therefore, a stock must meet the first test, and having an ROE above 27 percent is considered a best- case scenario. Micron Technology (NASDAQ:MU) and Mobil'nye Telesistemy (NYSE:MBT) both pass this test with flying colors.
- Pre-tax profit margins: According to Dreman, profit margins of at least 8 percent indicated a strong business, and he considered anything over 22 percent to be very impressive.Our model requires an 8% pre-tax margin to pass and considers anything over 22 percent to be a best-case scenario. Ares Capital Corp. (NASDAQ:ARCC) is one of the high scoring firms that earns high marks on this measure.
- Yield: Contrarian stocks, according to Dreman, can provide both high dividend yields and offer better appreciation potential than more popular stocks. In our Dreman-based model, therefore, we require yield of at least 1 percentage point higher than that of the Dow Jones Industrial Average. Annaly Capital Management (NYSE:NLY), with a current yield of 11.41%, passes this test.
- Debt-equity ratio: Finally, a company must have a low debt-equity ratio to guard against financial problems that could surface from high leverage. In our model, we require a debt-equity ratio of less than 20 percent (we exclude financial commpanies from this test because the nature of their business results in high debt levels). Petrochemical company Sinopec (NYSE:SHI) is favored for its ultra-low debt-equity ratio of 2.15%.
Contrarian investing isn't for the lighthearted, and I should note that our portfolios that track the Dreman model have had great periods of returns but long periods of underperformance as well. Still, those investors who maintain more of a contrarian mindset and appreciate the tenants of value investing would be well-served by looking at the Dreman-inspired model and learning from it.
Disclosure: I am/we are long AMCX, HRB, SC, MU, MBT, ARCC, NLY AND SHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.