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Contrarian Investment Strategies: The Next Generation
Beat The Market By Going Against The Crowd
by David Dreman
Contrarian Investment Strategies: The Next Generation is another excellent investing book by David Dreman.
Dreman mentions the stock market went nowhere for the seventeen years prior to 1982. This is a reality that many "investors" today can't imagine. Dreman says, "Before all else, a successful strategy requires a strong defense: it must preserve your capital."
Preservation of Capital is a key factor that many ride-the-hot-IPO investors miss. Many investors are seeking excitement in the "red" room of investing. In Contrarian Investment Strategies, Dreman uses a hypothetical example of a casino with two rooms.
One room, the "green" room lacks excitement, but stacks the chances of success in favor of the gambler. Few people are in the green room placing their bets, and the casino manager says it's a good thing, too, because the casino would go broke if people participated.
The other room is active and exciting, but in the "red" room, the odds are stacked in favor of the casino and people tend to lose. Most investors spend their time in the "red" room of investment because they are seeking excitement. Long-term, this fails to build wealth. Dreman introduces investors to the green room of investing-- contrarian investing.
Dreman shows that technical analysis doesn't work. (So, what else is new? We knew this.) But, then Dreman goes on to examine the performance of professional money managers, most of whom use fundamental analysis.
After allowing for the fact that career pressures and short-term performance demands significantly affect professional stock analysts, Dreman concludes professional fundamental analysts are still bound to fail simply because the great majority of people are very incapable of effectively processing large amounts of data and coming to a meaningful and accurate conclusion about the meaning of the data.
Yet, the more specific information investors are fed, the more confident they become in their predictions of a stock's behavior and value. Note, we said, they become more confident, not any more accurate.
Effective securities analysis is impossible due to the scope of the endeavor. For example, Dreman casually mentions of Hewlett Packard, "In 1996, it had revenues of over $38 billion and net profit of $2.675 billion and employed 102,300 people domestically and abroad. Foreign sales in 75 countries accounted for 56% of total revenue." Do you really think you can do fundamental analysis of such a company?
Dreman goes on to show that most analyst's earnings' estimates for the next upcoming quarter are usually off significantly and that valuation methods demanding precision are very dubious.
Further, Dreman notes that often company earnings follow their own random walk and that you can't use the past to predict the future in today's dynamic economy.
So, what's an investor to do? Take advantage of the one thing you can be certain of--the chronic overreaction of other investors. Buy out-of-favor stocks, as measured by low price-to-earnings ratios, low price-to-book values, low price-to-cash-flow ratios, or high dividend yields. Surprisingly, Dreman doesn't mention price-to-sales ratios at all, despite the fact that much evidence supports their use as a great measure of value.
Dreman points out that volatility is not the best measure of investment risk for the investor and he destroys the efficient market hypothesis and that higher reward is correlated with higher risk.
Dreman suggests that one category of stocks, GARP stocks (Growth at a reasonable price), can offer both value (i.e., low risk) and significant appreciation potential. The pharmaceutical stocks of 1993 are an example. These pharmaceutical companies offered significant capital appreciation potential, solid financial positions, and high dividend yields.
Buying out-of-favor GARP stocks "allows you the possibility of a home run, while staying safely in the value camp."
Contrarian Investment Strategies offers an eclectic investment strategy based upon Dreman's approach to investing. Dreman recommends using some basic fundamental analysis to assure the out-of-favor companies you buy are financially strong.
This book should be read by any serious investor who wishes to move into the "green" room of investing.
The Next Generation