Stock screening using David Dreman’s contrarian investment approach

Thursday, May 12 2011 by
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Stock screening using David Dremans contrarian investment approach

In brief

David Dreman champions a contrarian investment approach based on interpreting market psychology and using value measures to pick stocks that are out of favour with the market.

Background

Canadian-born Dreman founded his first investment firm in 1977 and is currently the founder, chairman and chief investment officer of Dreman Value Management LLC. He has written a series of highly acclaimed books and his best selling Contrarian Investment Strategies: The Next Generation, was published in 1998. He is a regular columnist for Forbes magazine.

Dreman attributes his investment approach to losing 75% of his net worth simply by following popular stocks in the late 1960s. A subsequent interest in analysing the psychology of the market and the emotions that can distort the valuations of fashionable stocks helped him forge a contrarian approach that seeks to take advantage of the misjudgements of other investors. Dreman invests in out-of-favour stocks, often in out-of-favour industries, that he identifies using relatively straightforward metric criteria.

"I buy stocks when they are battered. I am strict with my discipline. I always buy stocks with low price-earnings ratios, low price-to-book value ratios and higher-than-average yield. Academic studies have shown that a strategy of buying out-of-favor stocks with low P/E, price-to-book and price-to-cash flow ratios outperforms the market pretty consistently over long periods of time."

Criteria

  • Reasonable Price: P/E ratio below average. Dreman believes that investors tend to put too much emphasis and, as a result, overvalue stocks that have strong earnings visibility. Whereas, low P/E stocks with a perceived weakness in visibility, are often ignored. Dreman asserts that there is an inherent vulnerability in assessing stocks on a P/E basis because fashions for particular stocks and sectors can change rapidly. That gives the contrarian investor the opportunity to take advantage of a market correction, where popular stocks and sectors lose support, which he believes can occur within one year.
  • Dividend Yield: Yield above 1.5%. Not only does this provide insulation against a fall in value but it also contributes to a return on the investment.
  • Earnings Growth: Dreman’s aversion to relying too heavily on earnings estimates, together with targeting low P/E ratios and high dividend yields should not blur the importance of identifying growth stocks. The contrarian investment approach seeks to identify companies that are incorrectly priced by the market but nevertheless offer the prospect of longer-term growth. More specifically, Dreman’s…

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