Contrarian Investment Strategies
Praise for DAVID DREMAN
“David Dreman has been a keen student of psychology for many years. It is fascinating to see him combine his knowledge of recent advances in cognitive psychology with his vast understanding of financial markets. The result is a thought-provoking book providing valuable guidance for investors searching for opportunities amidst the risk and volatility in today’s investment world.”
—Paul Slovic, PhD, founder and president
of Decision Research and author of The Feeling of Risk
“Dreman is the grand master of a simple but psychologically challenging investment strategy: consummate contrarianism.”
—The New York Times
“If contrarian investing was a religion—and to many devotees within the Motley Fool community, it is—then David Dreman might be its prophet.”
—The Motley Fool
“Dreman’s standing among mutual fund investors is almost iconic . . . Dreman was an early adopter of behavioral finance, incorporating it into his investment philosophy . . . Dreman’s dedication to behavioral finance has been profitable for investors. The DWS Dreman High Return Equity Fund is the top-performing equity-income fund of the past 18 years, according to New York–based research firm Lipper.”
—Institutional Investor
“Dave Dreman is a world-renowned value manager. He may be creating even more value in Contrarian Investment Strategies as he focuses on current analysis and opportunity.”
— A. Michael Lipper, CFA, founder and president of Lipper Advisory Services, Inc.
“Skip the academics and just read Dreman.”
—Don Phillips, director, Morningstar, Inc.
“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 . . . Dreman, perhaps more than any other guru I follow, is a student of investor psychology . . . By targeting out-of-favor stocks and avoiding in-favor stocks, Dreman found you could make a killing.”
—John Reese, Seeking Alpha
“Dreman’s contrarian style of investing has earned him accolades from Wall Street as well as hefty returns . . . Next time you’re tempted to buy a red-hot stock, resist the temptation to jump on the bandwagon. According to Dreman—the king of contrarian investing—you would do far better buying stocks that are out of favor. And that’s not just his own experience talking: Study after study has proven him right.”
—Equity
David Dreman, chairman and managing director of Dreman Value Management, LLC, is one of the most successful and influential investment managers in history, and his name is synonymous with contrarian investing. In this major revision of his investment classic, which Warren Buffett called “that rarity—an extremely readable and useful book that will be of great value both to the layman and the professional,” Dreman introduces vitally important new findings in psychology that explain why the stock market is inescapably given to bubbles, panics, and periods of high volatility. He also shows how we can use these findings to reliably profit from market errors, crash-proof our portfolios, and earn market- beating long-term returns.
The need for these keen new insights and his powerful contrarian strategies has never been more urgent. The market crash of 2007–2008 left no doubt that there are glaring flaws in the theory underlying all of the other prevailing investment strategies—the efficient market hypothesis—as well as in the long-accepted theory of risk. These twin theories, and all of the popular investing strategies that are based on them, fail to account for major, systematic errors in human judgment that the powerful new psychology research explains, such as emotional overreactions and a host of mental shortcuts in decision-making that lead to wild over- and undervaluations of securities as well as fundamentally f lawed assessments of risk. Dreman’s contrarian strategies not only account for these dangerous psychological effects but allow investors to take advantage of them. Dreman presents a breakthrough new theory of risk and introduces vital findings about the hidden dangers of high-speed trading and its role in volatility; he also delves into the pernicious risk of flash crashes as well as how to prepare for inflation.
Updating all his signature charts of market movements and stock valuations that prove the remarkable power of his contrarian strategies, he shows how the strategies would have optimized returns during the “lost decade” that culminated in the 2007–2008 crash and would have positioned investors for marketbeating returns in the recovery. Enhancing his core methods for choosing stocks with a number of new techniques developed over the last decade, he shows why the “best” stocks are consistently overvalued while the so-called worst, contrarian stocks are undervalued, and he lays out his proven and simple rules for avoiding the pitfalls and spotting the bargains.
Based on breakthrough research and showing for the first time how the new psychological findings can be directly incorporated into investing strategy, this thoroughly revised edition of one of the most influential books on investment is an essential addition to every investor’s arsenal.
DAVID DREMAN is the chairman and managing director of Dreman Value Management, LLC, a firm that pioneered contrarian strategies on the Street and manages more than five billion dollars of individual and institutional funds. Regarded as the “dean” of contrarians, he is the author of the critically acclaimed Psychology and the Stock Market and Contrarian Investment Strategy. Dreman is also the senior investment columnist at Forbes magazine. Articles about the success of his methods have appeared in The New York Times, The Wall Street Journal, Fortune, Barron’s, Bloomberg Businessweek, and numerous other publications. He lives with his wife and daughter in Aspen, Colorado.
MEET THE AUTHORS, WATCH VIDEOS AND MORE AT
SimonandSchuster.com
• THE SOURCE FOR READING GROUPS •
JACKET ILLUSTRATION © AL AMY
COPYRIGHT © 2012 SIMON & SCHUSTER
Thank you for purchasing this Free Press eBook.
Sign up for our newsletter and receive special offers, access to bonus content, and info on the latest new releases and other great eBooks from Free Press and Simon & Schuster.
or visit us online to sign up at
eBookNews.SimonandSchuster.com
ALSO BY DAVID DREMAN
Psychology and the Stock Market:
Investment Strategy Beyond Random Walk
Contrarian Investment Strategy:
The Psychology of Stock-Market Success
The New Contrarian Investment Strategy
Contrarian Investment Strategies:
The Next Generation
This publication contains the opinions and ideas of its author and is intended to provide useful advice in regard to the subject matter covered. It is sold with the understanding that in this publication the author and publisher are not engaged in rendering legal, financial, or other professional services. If the reader requires expert assistance or legal advice, a professional advisor should be consulted directly.
The strategies outlined in this book may not be suitable for every individual, and are not guaranteed or warranted to produce any particular results. The author and publisher specifically disclaim any responsibility for any liability, loss, or risk, personal or otherwise, which is incurred as a consequence, directly or indirectly, of the use and application of any of the contents of this book.
Free Press
A Division of Simon & Schuster, Inc.
1230 Avenue of the Americas
New York, NY 10020
www.SimonandSchuster.com
Copyright © 1998,
2011 by David Dreman
All rights reserved, including the right to reproduce this book or portions thereof in any form whatsover. For information address Simon & Schuster Subsidiary Rights Department, 1230 Avenue of the Americas, New York, NY 10020.
FREE PRESS and colophon are trademarks of Simon & Schuster, Inc.
The Simon & Schuster Speakers Bureau can bring authors to your live event. For more information or to book an event contact the Simon & Schuster Speakers Bureau at 1-866-248-3049 or visit our Web site at www.simonspeakers.com.
Designed by Katy Riegel
Library of Congress Cataloging-in-Publication Data
Dreman, David N.
Contrarian investment strategies : the psychological edge / David Dreman.
p. cm.
1. Investment analysis. 2. Investments—Psychological aspects. I. Title.
HG4521.D727 2012
332.601'9—dc232011023716
ISBN 978-0-7432-9796-7 (print)
ISBN 978-1-4516-2895-1 (ebook)
Revised and updated edition of Contrarian Investment Strategies: The Next Generation.
For Meredith and Ditto
Contents
Introduction
PART I: What State-of-the-Art Psychology Shows Us
1. Planet of the Bubbles
2. The Perils of Affect
3. Treacherous Shortcuts in Decision Making
PART II: The New Dark Ages
4. Conquistadors in Tweed Jackets
5. It’s Only a Flesh Wound
6. Efficient Markets and Ptolemaic Epicycles
PART III: Flawed Forecasting and Poor Investment Returns
7. Wall Street’s Addiction to Forecasting
8. How Big a Long Shot Will You Play?
9. Nasty Surprises and Neuroeconomics
PART IV: Market Overreaction: The New Investment Paradigm
10. A Powerful Contrarian Approach to Profits
11. Profiting from Investors’ Overreactions
12. Contrarian Strategies Within Industries
13. Investing in a New, Alien World
14. Toward a Better Theory of Risk
PART V: The Challenges and Opportunities Ahead
15. They’re Gambling with Your Money
16. The Not-So-Invisible Hand
Acknowledgments
Notes
General References
Index
Footnotes
Contrarian Investment Strategies
Introduction
SOME THINGS SEEMED clear as I wrote this introduction in late August 2011. Although we have recently survived the worst economic and market period since the Great Depression, we are on anything but a solid footing today. Many market experts call the 2000–2009 period the “lost decade.” People lost heavily in the dot-com crash of 2000–2002 and even more in the subprime crash of 2007–2008, which not only dented their remaining savings but also substantially knocked down the prices of their homes. So much for the idea that modern investment methods and critical information delivered in nanoseconds would make this nearly impossible.
By June 2011, stock prices doubled from their lows of March 2009. But it wasn’t to last. After moving to its high of up 111 percent from the March 2009 low, the market took one of its sharpest dives in decades. From the July high through late September, the S&P 500 index free-fell almost 20 percent, a drop that cost investors more than three trillion dollars. The plunge was considered by many senior money managers to be the beginning of a new bear market as business activity concomitantly slowed dramatically. From almost universal investor agreement that the world economies and markets were improving, fears built up rapidly that we were entering a new recession. Most investors were bewildered and a good number were terrified. Who could blame them? Along with a frightening drop in prices reminiscent of September to December of 2008, volatility, exceptionally low for eighteen months, skyrocketed in four days in August 2011; the Dow Jones Industrial Average dropped 635 points, then rose 430 points, then dropped 520 points, and finally rose 423 points.
The result was confusion and panic rarely seen. Fearing a sharp recession, both Americans and foreigners poured into U.S. Treasuries even though they had been downgraded by Standard and Poor’s, one of the nation’s foremost credit-rating agencies, for the first time in U.S. history. Nevertheless investors rushed into them and into gold, which they regarded as the only secure investments available. Treasuries shot up a remarkable 15 percent from the beginning of the July 2011 stock market decline.
Hundreds of thousands of other investors bought gold, and in six months it rocketed from $1,400 to $1,900. Buying Treasuries because it was believed we were on the cusp of a major recession and buying gold because runaway inflation was expected in a highly overheated economy were diametrically opposite investor reactions to the same market events. It was like betting heavily on a horse to both win and come in trailing the pack in a major race. The investor, like the bettor in the analogy of the race, is almost destined to lose either way, because the house keeps a healthy percentage of both bets.
To further complicate recent developments, the over-two-month battle in July–August of 2011 to raise the U.S. debt limit, thereby preventing a U.S. default, which went down to the wire, shook the confidence of many large foreign investors in Treasuries from Russia to China to Japan, and again injected major fear into U.S. markets. The debt freeze has been estimated to eventually cost over one million domestic jobs, because state and municipal governments cannot get the money from the federal government to finance road and highway construction, maintenance, and other badly needed infrastructure projects. Our politicians certainly are far from winning public accolades for their performance. Recent public opinion polls have shown approval for congressional actions in the 20 percent range. Unfortunately the negativity does not stop there.
Many people of all political persuasions have serious questions about the quality of our economic leadership, at both the Treasury and the “independent” Federal Reserve—a concern that now stretches from the Clinton years through the Bush presidencies and the first two and a half years of the Obama administration—as well as a deep distrust of the investment bankers and banks who together came close to wiping out both our own and the global financial system in 2007 and 2008.*1 The Federal Reserve, for example, quietly loaned the biggest problematical banks 1.2 trillion dollars in 2008. Almost half of the largest borrowers were foreign banks. These loans were about the same amount as U.S. mortgage borrowers currently owe on 6.5 million delinquent and foreclosed mortgages.1 The delinquent mortgage holders naturally received nothing, while many officers of the biggest troubled banks received mind-boggling bonuses and severance payments.
So where do markets and the economy stand today? The truth is that nobody knows. Horrible exogenous events can tempt you to give up your faith in the bullish case for stocks. Who could foresee the earthquake in Japan in March 2011 measuring 9.0 on the Richter scale or the giant tsunami that followed only minutes later, which created enormous devastation as well as taking thousands of lives? Those were followed within days by four adjacent nuclear plants of the Tokyo Electric Power Company being on the verge of a meltdown that threatened to take many thousands of additional lives and send markets worldwide plummeting because of the fear that this disaster would thwart global economic growth for years.
Small wonder that many people worry that even fiercer winds are not far off, while others, like myself, think the great storm is almost over and markets will continue to move higher over time, albeit with a full complement of bone-jarring such as we have just seen. One thing, though, is certain: the times are very different today from a little over a decade ago. All the investment standards we were comfortable with for many years appear to have fallen by the wayside. Many of today’s financial teachings are actually toxic to your portfolio. For many generations, investors kept their money in bonds and believed they were investing prudently. Doing so today would bring about disaster. Tr
easury bills, supposedly the safest investment there is, have cost investors 77 percent of their purchasing power since 1946.
Can we depend on savvy and knowledgeable money managers to get us out of this quandary? No, that won’t work either. They consistently underperform the market over time. John Bogle, the ex-chairman of the Vanguard Group of Mutual Funds, is an expert on mutual fund performance. Bogle heads Financial Markets Research Center, which showed that between 1970 and 2005, a period of thirty-six years, only 2.5 percent of the 355 equity mutual funds in existence in 1970 outperformed the S&P 500 by at least 2 percent. A whopping 87 percent of the funds either didn’t survive or underperformed the market.2
Then what are we left with? Once again, as Plato noted more than 2,400 years ago, necessity will prove to be the mother of invention. The sky is not falling; there will be some excellent opportunities ahead for those who are not fixated on the past. I’m convinced that the country is strong enough to put the last decade’s devastating crashes behind it. It is obvious that the mistakes and incompetence of the policy makers and the level of greed that caused the subprime collapse cannot be brushed aside and soon forgotten, but in this book we are concerned primarily with how to rebuild your savings, how to structure your portfolio to withstand likely conditions ahead, and how to take the proper actions that will let your portfolio prosper again over time.
That is a tall order, requiring us to reexamine and fundamentally challenge the investment theory most of us have used for generations. We must keep what is useful but discard what doesn’t work, basing this decision not on anecdotal reports but on solid empirical performance data. It is, however, admittedly not a walk in the park.
In the opening chapters of this book, I will make the case that not only the recent crashes but a host of powerful research findings to be introduced have definitively proven that the efficient-market hypothesis (EMH), the reigning investment paradigm, which states that sophisticated investors always keep prices where they should be, is incapable of providing accurate explanations of why current investment theory has failed, often miserably. Its basic assumptions are going to be thoroughly analyzed, and as we analyze them, we’ll see how they have been clearly refuted. The error at the heart of EMH, we will see, is that it simply does not recognize that psychology plays a part in your investment decisions. The efficient-market theorists—and most economists—do not believe that psychology, with its “softening” of human rationality, should be allowed a role in investment or economic decision making. Instead, it seems, they have plastered the lipstick of complex mathematics onto an academically abstract piggy to sell a lot of theoretical bacon. The deceit is certainly not intentional; the theory’s supporters believe it, despite numerous refutations of many of its premises. Science has always had a fair share of such sincere but mistaken researchers who simply won’t give up on a cherished theory. In an important sense the book is a new investment paradigm or method of investing. A new paradigm is normally accepted only when an old one can no longer explain events heretofore believed to be fully explicated by it. We are at just such a crossroads today.