Dreman Contrarian | Mispriced stocks

David Dreman is synonymous with contrarian investing through his books and the Forbes column. This article shows how to use a contrarian screen to identify stocks that may be mispriced.

Mention contrarian investing and you can't avoid David Dreman. He is synonymous with contrarian investing through his books and the long-running Forbes column.

Unlike the efficient market theory assumed by traditional academic studies, Dreman sees stocks and markets driven by emotions that often push prices from their intrinsic value. Dreman feels the best approach to beating the market is to follow the principles of contrarian investing.

Check out ValuePickr's Dreman Contrarian stock screen selections for the Indian stock market, here.

Dreman Contrarian Value Investing Approach

Contrarian Investment Strategy: The Psychology of Stock Market Success" (1980) is an investment classic and his first book - the primary source and inspiration for this article, and the stock screen.

Stock Picking strategy: contrarian buy stocks with low P/E, low P/B,and high yield

In an interview for Kiplinger's Personal Finance Magazine in 2001, Dreman explained the gist of his approach in his own words as quoted alongside:

"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."

Dreman seeks companies with a high dividend yield that the company can sustain and possibly raise. The yield helps to provide protection against a significant price drop, and also contributes to the total return of the investment.

He favors large- and medium-sized companies in his approach for three primary reasons—greater chance for a rebound if there is a company misstep, greater market visibility with the rebound, and a reduced chance of "accounting gimmickry."

In his observations, Dreman has found that fewer large firms have gone completely out of business. Large companies have greater managerial and financial resources to weather a company or industry slowdown or problem. However, many of these once-troubled firms have experienced substantial turnarounds coupled with significant price appreciation. Dreman feels that with our dynamic economy, these turnarounds can occur very quickly.

Stocks of rebounding large companies tend to be in the public eye and get noticed more quickly when things go better for the company. This should result in a higher valuation for a given level of earnings. An increase in earnings, coupled with an increase in the multiple which investors are willing to pay for a given level of earnings, translates to significant price increases.

Dreman also feels that it is important to consider the financial strength of a company when pursuing a contrarian investment strategy. A strong financial position enables a company to work through a period of operating difficulty often experienced by out-of-favor stocks. Financial strength also helps to provide a measure of safety for the dividend payout.

Being a contrarian does not imply that an investor should purchase a company just because it has a low price-earnings ratio or a high dividend yield. A successful contrarian uses these valuation techniques to help identify stocks that may be misspriced. The companies are only attractive if they are expected to grow and prosper in the future.

Dreman seeks companies with a higher rate of earnings growth than the S&P 500 both in the immediate past and the immediate future.

Dreman Contrarian Stock Screen Design

Objective

Use contrarian valuation techniques to help identify stocks that may be misspriced. The companies are only attractive if they are expected to grow and prosper in the future.

Primary Criteria

Criteria to locate stocks that match our screening objective

1. Large & Medium sized companies - Market capitalization is in the top 70% of the entire stocks database

2. The price-earnings ratio is in the lower 40% of the entire stocks database

3. Financial strength - Debt-to-Equity ratio is less than the sector's median Debt-to-Equity ratio

4. Dividend Yield is greater than 1.5

Secondary Criteria

Criteria that ensure that the companies passing the primary screen do not meet our objectives just by coincidence, but because they are deserving candidates and truly meet our objective. Usually these are useful to eliminate the duds from creeping in.

1. Earnings growth rate for last quarter higher than the median growth rate

2. Earnings growth rate for last financial year is higher than the median growth rate

3. Estimated earnings per share for current year is higher than last financial year

4. Estimated earnings per share for next financial year is higher than estimated for current financial year

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