Contrarian Investment Rules – Part 1

March 19, 2009 | Comments (9)

Contrarian Investment Rules – First Part

Contrarian Investment Rules

Contrarian Investment Rules

I am currently reading Contrarian Investment Strategies by David Dreman and enjoying the rules that pop out throughout the book. There are 41 in total for the contrarian. There are many obvious rules. My comments are in bullet points and the highlighted rules are the ones I found interesting.

The list of 41 rules is quite long so I’ll break it into 2 parts. Part 2 will be posted tomorrow.

Contrarian Investment Rules 1-20

Rule 1: Do not use market-timing or technical analysis. These techniques can only cost you money.

Rule 2: 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.

  • Having too much information and thinking that one has mastered the details causes the investor to become overconfident.

Rule 3: Do not make an investment decision based on correlations. All correla­tions in the market, whether real or illusory, will shift and soon disappear.

Rule 4: Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.

Rule 5: There are no highly predictable industries in which you can count on an­alysts’ forecasts. Relying on these estimates will lead to trouble.

  • Analysts cannot predict the future any better than you and me.

Rule 6: Analysts’ forecasts are usually optimistic. Make the appropriate down­ward adjustment to your earnings estimate.

  • Always at the upper range in my experience

Rule 7: Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

Rule 8: 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. The past gives some frame of reference but cannot be exact.

Rule 9: 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.

Rule 10: Take advantage of the high rate of analyst forecast error by simply in­vesting in out-of-favor stocks.

Rule 11: Positive and negative surprises affect “best” and “worst” stocks in a di­ametrically opposite manner.

  • Interesting point. He is saying that beaten down stocks don’t go down as much because nobody expects much, but if it does better, everyone is surprised and up it goes. Vice versa for darlings.

Rule 12: (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.

Rule 13: Favored stocks under-perform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

Rule 14: Buy solid companies currently cut 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.

  • Not a fan of buying companies based on low ratios

Rule 15: 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.

Rule 16: 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.

  • Very guilty on this one. My expenses are too high.

Rule 17: Buy only contrarian stocks because of their superior performance char­acteristics.

  • Disagree

Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more indus­tries (if your assets are of sufficient size).

  • I’ve written about diversification here. Dreman is more of a mechanical investor so he doesn’t have to keep up with 20-30 companies. The point about industries is relevant.

Rule 19: Buy medium-or large-sized stocks listed on the New York Stock Ex­change, or only larger companies on Nasdaq or the American Stock Ex­change. (Obviously American centric here)

  • Disagree. This isn’t contrarian.

Rule 20: 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.

That is the first part of the Contrarian Investment Rules. Be sure to visit tomorrow for the remaining half.

  • http://widemoatinvesting.wordpress.com Wide Moat

    So who do you see as his intended audience? Portfolio managers, DIY investors? If the latter, I disagree as well with Rule 19. The DIY won’t find much of an edge on the big companies.

    Wide Moat’s last blog post..Concentration or Diversification

  • It’s the data

    You say you disagree, but the point of the book is that he is developing rules based upon what would have worked historically. You say you disagree with buying on low ratios yet that is really the basis of the whole book. Historically if you had divided the market into fifths by P/BV, P/E, etc and bought the lower fifth each year you would have beaten the market. So to say you disagree with this is kind saying you disagree with the premise of his whole book. While this is tough to do and contrarian, that is why he spends so many pages talking about the psychology of investing and keeping your discipline and emotions in check.

    I like this strategy, and then when you combine it with “value investors add value,” meaning that you probably can’t afford to buy the entire bottom 5th, but you can hand pick a large chunk of them, you can probably do pretty well. For those who haven’t head on over to the library and read the book, it is an excellent read.

  • http://www.oldschoolvalue.com Jae Jun

    I’m about halfway through the book and yes, I do disagree with a majority of it. Dreman like all other fund managers is concerned with beating the market which is one of the first points I disagree with. A hefty amount of the book is also focused on discussing historical numbers. Some were worthwhile to note but not all. I’m sure it helps in strengthening the case but other disciplines (value, growth, trading) all have their own data to back up why their strategies work better.

    My thoughts would be to use it as a screen, but did Dreman really have to write so much for a screen with low ratios?

    I do like the psychological aspect of the book but overall mechanical investing doesn’t suit me. I love finding out about companies, learning what they do and how they do it. It’s the details that make it interesting for me which Dreman says that we shouldn’t bother with.

    @Wide Moat
    It is directed to the DIY investor. Agree that you’re not going to have much of an edge on larger companies unless they are really beaten down.

  • http://can-turtles-fly.blogspot.com/ Sivaram Velauthapillai

    Good recap Jae. Dreman had a disastrous year last year but he’ll still one of the top contrarians IMO. I’m contrarian wanna-be ;) , although a concentrated investor, and I think he captures the core tenets of contrarian investing.

    The key point I learned from the book–and this was actually shocking to me when I was a total newbie–is that out-of-favour, poorly performing, stocks rise on bad news, while popular stocks actually fall on good news. I think he spends a lot of time on it (some of it seemingly repetitious) to prove this point. The low quartile outperforms the top quartile even when news is bad for the beaten down ones. This is one of the things that gives me faith for investing in distressed stocks (although distressed or beaten-down ones are very risky and often value traps.)

    As for the point about buying mid-cap or larger, I have to disagree with WideMoat and Jae if we are talking about contrarian situations. I think sticking with mid-cap or larger is fine if you are a contrarian. Since contrarians, and certainly what Dreman would suggest involves, buying out of favour stocks, I would argue that the potential return is arguably as attractive as many small-caps or smaller ones. Some of Buffett’s biggest successes were with out of favour mid-caps or large-caps. Certainly Coca-Cola and Gillette were large-caps. But, someone correct me if I’m wrong, his investments in Washington Post and American Express may have been in mid-caps or large-caps. I’m not really sure if Amex was a large-cap back in the 60′s but supposedly it was the leader in traveler’s cheques and the like, so it may have been a mid-cap (rather than small-cap). Washington Post may also not have been small cap although I’m not entirely sure.

    However, I think for non-contrarian investors (i.e. not looking at a beaten down, distressed, stock,) small-caps or microcaps will beat the larger ones.

    Anyway, just my opinion… good post…

    Sivaram Velauthapillai’s last blog post..One of the few irreversible things in life… decline of world languages

  • Value Investing with the Masters

    I agree about reading it for the details. It took me about 7 or 8 detailed books like this to develop my own screens and calculations. Is my system the best, far from it, but it is fun and interesting to develop your own that makes sense to you and is within your capability. Full agreement that at the very least Dreman offers a good starting point for basic screening and the logic to back them up.

    He is very long winded and tends to beat the dead horse over and over, but the book was still an easy read.

    For a good follow up read “Value Investing with the Masters.” Also a great read with specifics. Take these twenty guys ideas and blending makes for an easy start to value investing.

  • http://www.oldschoolvalue.com Jae Jun

    Once I get through the list of books that are waiting to be read, I’ll have to take a look at “Value Investing with the Masters”. Thanks.

  • John

    I personally love this style of investing. MSFT is PE 11, P&G 15, what more do you need to know just buy them, but if you insist:

    MSFT
    GP 80%
    OP 40%
    NET 31%
    ROE 46%
    P/B 4.6
    Any of us mortals starting a business, we would be super human to achieve half those numbers

    P&G
    GP 52%
    OP 20%
    NET 14%
    ROE 17%
    P/B 2.77

    Personally I just buy em it’s a no brainer.

    detailed Value investing is the most brillant form of investing because it makes you into a good business person, with a great understanding for business, you can go in many different areas with it. But you also have to recognize what is under your nose.

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