Chairman David Dreman, a pioneer in the field of contrarian investment strategies and behavioral finance, began the current firm in , after leading predecessor firms dating back to Since its founding, the firm has consistently stayed true to the contrarian style of investing. This research has led to five books on the topic. These works include Mr.
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Contrarian Investment Strategies provides a clear synthesis of the research that backs value investing. One of the strongest sections of the book showed how value stocks weathered negative earnings surprises and leapt at positive surprises, while growth and concept stocks hardly budged at positive earnings surprises and plummeted on misses. The book ends by exposing the pitfalls of IPOs, small caps and index investing.
Even understanding these forces, it is hard to stay unaffected by psychological pressures. Consistently push up the prices of the best stocks and ignore the poor stocks - not being able to see any issues pushes prices up to levels that are too high.
If there is total pessimism, any good news will result in prices rebounding. Low PE, low price to book value, Predictable, systematic investor errors stem from psychology, notably overreaction, overconfidence and inability to process complex data. Low PE, low price to book value, low price to cash flow, dividend yield.
They extrapolate positive or negative outlooks well into the future, pushing prices of favoured stocks to excessive premiums and out of favour stocks to deep discounts. After earnings of other surprises, investments previously considered to be the best underperform, while those considered to be the worst significantly outperform, as both regress towards a more average valuation. The hypothesis also states that the maximum price swing is produced by negative surprises on best stocks and positive surprises on worst.
Finally, the overreaction hypothesis holds that even without the occurrence of an event trigger, the best and worst investments regress towards the market average. It is not changes in underlying outlooks that appear to be the primary cause of the major price re-evaluations of best and worst stocks, rather it is the overreaction to the exciting or lacklustre prospects of companies that often results in best stocks being priced too dearly, and worst stocks much too cheaply. The push toward an average rate of return is a fundamental principle of competitive markets.
Author prefers an eclectic approach, adding five fundamental research indicators to picking the low PE stocks: strong financial position, favourable operating and financial ratios, higher earnings growth, conservative earnings estimates, above average dividend yield. It is difficult to take unpopular positions for long periods, even if they are right in the end. Contrarian strategies succeed because investors do not know their limitations as forecasters.
As long as investors believe they can pinpoint the future of favoured and out of favour stocks, you should be able to make good returns on contrarian strategies. Human nature being what it is, this edge should continue for a few years longer. Heuristics - representativeness, availability bias, anchoring, hindsight bias, Difficulty forecasting - more things can happen than will happen.
Markets are complex adaptive systems - earnings forecasts depend on large numbers of underlying assumptions, many of which are rapidly changing and hard to quantify, which means their accuracy is always in doubt. Analysts have a tendency to overconfidence. Analysing the subsequent market action after a crisis also makes it clear that there is a definite way to react to a crisis and a very high probability that you can profit, regardless of whether the roots of the crisis are financial, monetary or political.
Difficult to buy however, because the prevailing wisdom is things will get worse, and cheaper. Although gut wrenching, holding and even buying in a panic is a winning strategy. The nagging question however if whether this time is different still goes through your mind - none of us can escape the anxiety and doubt that permeates a crisis.
Progress, far from consisting in change, depends on retentiveness. That is, your financial progress cannot be secured by embracing the fashion of the moment. Is it because they are lucky that great men become great? No, but being great they been able to master luck - Napoleon.
Contrarian Investment Strategies: The Classic Edition