Kiplinger once referred to value investor David Dreman as "the consummate contrarian." Author of five books, a Forbes contributor, and the founder of Dreman Value Management, this against-the-grain investor has built a long and successful career by following his own path.
Dreman is also a scholar in the area of investor psychology (also referred to as behavioral finance), which is no coincidence, as his company's website shows:
"Conventional financial theory assumes that all investors are rational. However, in reality, emotions can often lead to irrational investment decisions, creating bubbles and panics. Behavioral finance offers clear explanations where current financial theory often fails to recognize and possibly take advantage of mistakes both professionals and individual investors make."
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. Dreman identified these undervalued companies by comparing their share prices to four different financial variables that gauged the strength of the underlying business: earnings, cash flow, book value and dividend yield.
Dreman conducted studies from 1970 to 1996 in which he examined returns of stocks that were in the bottom 20% of the market for price-to-earnings, price-to-cash flow, price-to-book and price-to-dividend ratios. The average annual returns corresponding to those stocks with the lowest ratios were:
- Price-to-earnings: 19%
- Price-to-cash flow: 18%
- Price-to-book: 18.8%
- Price-to-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 but undervalued companies. The first test a stock must pass to be favored by this model is that it falls in the bottom 20% of the market for at least two of the four previously mentioned ratios. Once that is achieved, the stock must meet the following additional criteria:
1. Market Capitalization
Dreman has said that larger companies are more in the public eye and therefore tend to have more staying power. These types of companies are also less apt to use 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.
2. Earnings Trend
Dreman has said he likes to see a rising trend in earnings, so our model requires earnings in the most recent quarter to exceed those of the previous quarter.
For noncyclical companies only, Dreman prefers earnings growth to exceed that of the S&P 500 index, so he examined earnings per share 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 respective numbers 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 that are suffering from long-term financial problems in the underlying business:)
3. 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.
4. 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.
This is an important way to measure how profitable a company is, and Dreman has said that a solid ROE ensured against structural flaws in the company's operations. He has required ROE to be greater than that of the top one-third of the 1,500 largest-cap stocks (and considers anything more than 27% to be outstanding). To pass our screen, therefore, a stock must meet the first test, and an ROE of more than 27% is considered a best-case scenario.
6. Pretax Profit Margins
According to Dreman, profit margins of at least 8% indicated a strong business, and he considers anything more than 22% to be very impressive. Our model requires an 8% pretax margin to pass, and considers anything more than 22% to be a best-case scenario.
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 a dividend yield that is at least 1 percentage point higher than that of the Dow Jones Industrial Average.
8. Debt-to-Equity Ratio
Lastly, 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%. (We exclude financial companies from this test because the nature of their business results in high debt levels).
After a few challenging years, our Dreman-based model portfolio performed well in 2016, returning 25.7%, vs. the S&P 500's 9.5% return. The chart below outlines four stocks that earn high marks according to this screen: