How David Dreman Picks Great Stocks (34 Contrarian Investing Rules)

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David Dreman is one of the famous value investors. He is the founder and Chairman of Dreman Value Management. In this article, I discuss 34 of the investing rules he laid out in his book, Contrarian Investment Strategies. I absolutely love the rules-based approach, I have previously discussed the 16 Life Lessons that I learned from Investing, you will find a lot of parallels with the principles laid out in this article.

At Aikido, all of our investment strategies are rules-based. Purely quantitative. All long-term. This form of investing is close to my heart. So, without any further adieu – here are some life-changing investment principles:

David Dreman

1. Timing the market

Do not use market-timing or technical analysis. These techniques can only cost you money.

2. Occam’s razor (Simplicity beats complexity)

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.

3. Correlations

Do not make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.

4. New investment methods

Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.

Note: David Dreman was born in 1936 and was a very successful value investor. One should always be sceptical of new methods, but should not shove their head in the sand and refute techniques that do work. For instance, factor investing, a form of quantitative investing has become increasing popular over the last decade – growing at 30% year over year since 2012. It is new, but very powerful. It is the evidence-based, scientific, data-driven approach to picking stocks. Value (Which Dreman is famous for), is just one of 5/6 investment factors. To learn more about quantitative investing and it’s powers, check out this blog.

5. Analyst’s forecasts

There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble.

Note: UC Davis professor Brad Barber studied the buy and sell recommendations of Wall Street analysts. What he found was that the analysts buy recommendations underperformed by 3% per month, while their sell recommendations outperformed by 3.8% per year! I previously discussed how wrong analysts often are here, along with some techniques millennial investors can use to improve their investing.

6. Don’t be optimistic

Analysts’ forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimate.

7. Security analysis is precise up to a point

Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

Note: There are many ways of valuing a company. Comparables (fundamental ratios), Formulae (DCF / DDM), and others. Do not rely on one method alone, use many to come up with your valuation.

8. Past performance does not indicate future results

It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past accurately to estimate the future.

9. Mentally prepare for the worst-case scenario

Be realistic about the downside of an investment, recognizing our human tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.

10. Invest in undervalued, out-of-favour stocks

Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.

11. the inverse effect of news on stocks

Positive and negative surprises affect “best” and “worst” stocks in a diametrically opposite manner.

(A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.

(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.

(C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.

(D) The effect of an earnings surprise continues for an extended period of time.

12. Mean reversion is a very powerful force

Favored stocks under-perform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

Note: This effect is called mean reversion. The emotions of humans have a similar tendency called the Hedonic Treadmill; whether we are really happy, or really sad, we always come back to a stable state.

13. Use these Value metrics

Buy solid companies currently out of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

Note: Other value metrics of interest are Price-to-sales, ev-ebitda, ev-ebit, price-to-free-cashflow

14. Don’t speculate

Don’t speculate on highly priced concept stocks to make above-average returns. The blue chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman or woman.

15. Don’t overtrade

Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price- to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.

Note: This one can’t be stressed enough. Follow a quantifiable strategy, don’t look at your portfolio too much, and DON’T TRADE unless it is specifically part of the strategy.

16. Be contrarion

Buy only contrarian stocks because of their superior performance characteristics.

Note: To do better than everyone else, you have to be different from everyone else. Rule of thumb for long-term success: Do the opposite of whatever the masses are doing

17. Portfolio size

Invest equally in 20 to 30 stocks, diversified among 15 or more industries (if your assets are of sufficient size).

Note: You are 90-95% diversified with just a 20 stock portfolio. However, the optimal Sharpe ratio (ie. Risk vs. Return) for a value portfolio comes in around a 10 stock portfolio.

18. Market Capitalization

Buy medium-or large-sized stocks listed on the New York Stock Exchange, or only larger companies on Nasdaq or the American Stock Exchange.

Note: As of 2021, this mean $2B upwards. You will sacrifice some performance by doing this, missing out on the Size factor. Though, the lion’s share of returns for small companies comes from sub $25M – these companies are incredibly volatile, so be prepared for a bumpy ride.

19. Buy cheap in each industry

Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.

20. Keep an eye on Price-to-earning

Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.

Note: The market is in a frenzy right now and you will struggle to find this scenario often. The P/E of the S&P500 is currently 34! Thje historical median has be 14.8. Though the P/E ratio has fallen out of disuse a little in the last decade with the rise of tech companies and startups that reinvest all their profits, thus keeping earnings down, but growing their sales. Check out Price-to-sales ratio, it is a better indicator for the 2020’s.

21. Every point in history is a little bit different and not directly comparable

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

22. Be VERY aware of short term performance of money managers

Don’t be influenced by the short-term record of a money manager, broker, analyst or advisor, no matter how impressive; don’t accept cursory economic or investment news without significant substantiation.

Note: Mean reversion works on money managers the exact same way it does everything else. In fact, 90% of fundamental fund managers have failed to beat the market over the past 15 years. Indeed, over the past 20 years, fund managers have averaged a return of just 4.67%! As Malcolm Gladwell discusses in his book Blink, more information doesn’t yield better results, in fact we often make better decisions with a fraction of the information.

23. Base rates are everything

Don’t rely solely on the “case rate.” Take into account the “base rate” – the prior probabilities of profit or loss.

Note: This is how often a strategy has outperformed the market in the past and bad the worst downturn was. We have this information for every Aikido strategy in the catalog.

24. Beware of recent returns

Don’t be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the “case rate”). Long term returns of stocks (the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

Note: Momentum is an established factor. Recent performance should not be completely disregarded, but rather used in conjunction with other factors.

25. Patience is a virtue. Good things, take time

Don’t expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.

The push toward an average rate of return is a fundamental principle of competitive markets.

27. Investors will stay irrational longer than companies will

It is far safer to project a continuation of the psychological reactions of investors than it is to project the visibility of the companies themselves.

28. Buy the really big dips

Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell.

29. In crashes, companies are frequently far more undervalued than they deserve to be

In a crisis, carefully analyze the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny

30. David Dreman’s Key rules: Diversify and Value Invest

(A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clinker.

(B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

31. Volatility is not risk

Volatility is not risk. Avoid investment advice based on volatility.

Note: I absolutely love this one. Risk is how likely someone is to sell a stock, not the volatility of the stock itself.

32. Rules for investing in small caps

(A) Small-cap investing: Buy companies that are strong financially (normally no more than 60% debt in the capital structure for a manufacturing firm).

(B) Small-cap investing: Buy companies with increasing and well-protected dividends that also provide an above-market yield.

(C) Small-cap investing: Pick companies with above-average earnings growth rates.

(D) Small-cap investing: Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one.

(E) Small-cap investing: Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.

(F) Small-company trading (e.g., Nasdaq): Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.

33. Investing in small cap is usually a lot more expensive

When making a trade in small, illiquid stocks, consider not only commissions, but also the bid /ask spread to see how large your total cost will be.

34. Beware of get-rich-quick mutual funds

Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff. A given in markets is that perceptions change rapidly.

Conclusion

And that’s just about all the investing principles. There is a lot in there, so take some time to digest. At Aikido, we’re quant to the core. You check out some of our long-term quantitative investment strategies here.

Until next time,

Take it easy.

Shane

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