(AP Photo/Richard Drew)
Disclosure: John Reese and/or his private clients are long KKR, AT&T, Oaktree Capital Group, LLC and Enel Generacion Chile SA.
Newton's Laws of Motion describe the relationship between a body, the forces acting upon it, and its motion in response to those forces. The third of these laws states: For every action, there is an equal and opposite reaction. Granted, the laws of physics don't apply to investor behavior. But if they did, we'd have a universal mess on our hands.
Investor behavior is firmly rooted in psychology, a notion that's evident in all the guru-inspired stock screening models I created for Validea. One of these gurus, however, dug into this field of study more than most others--David Dreman, author of both Psychology and the Stock Market (1977) and Contrarian Investment Strategies (1980). In fact, Dreman (who founded his own investment company) is on the board of directors of the Institute of Behavioral Finance, publisher of the esteemed Journal of Behavioral Finance.
In his books, Dreman presents an implementable, proven strategy for investing while also addressing the psychological reasons that many investors fail. He argues that investors can't follow simple strategies to beat the market because they are prone to overreaction. Under certain, well-defined circ*mstances, in fact, Dreman argues that investors overreact predictably and systematically.
For example, investors tend to overprice stocks that are considered up-and-coming, "hot" prospects. Conversely, if a stock's price has been dropping and the company is making negative headlines, investors typically underprice it. When you mix investors' tendency to overreact together with frequent surprises in the market, you arrive at the core of the Dreman contrarian approach—that inspired my corresponding stock screening model.
Surprises are common in the market, according to Dreman, and because "good" stocks are often overvalued, positive surprises really can't boost their values much. Negative surprises, however, can have a very unfavorable impact on these stocks. Similarly, although there isn't much downside when unpopular stocks get negative press, they stand to gain significantly should a positive surprise surface. His conclusion: Buy out-of-favor stocks because surprises happen frequently and investors can be rewarded handsomely for positive ones. Although a logical concept, Dreman found that even those who understood it had trouble adhering to it.
In order to find stocks that are undervalued based on their fundamentals, Dreman compared a stock's price to four different financial variables that measured the strength of the company's underlying business operations: earnings, cash flow, book value and dividend yield. He looked for ratios falling among the bottom 20% of the overall market, which is how I also structured my Dreman-based screening model (in order to pass my screen, at least two of the four ratios must fall within that range).
Price-Earnings Ratio: Global investment firm KKR & Co. L.P. (KKR) meets this requirement.
Price-Cash Flow Ratio: If a company's share price is low relative to its operating cash flow, Dreman viewed this as a good indication that the stock is undervalued (he defined cash flow as after-tax earnings plus depreciation and other noncash charges). Communications company AT&T (T) fits the bill.
Price-Book Ratio: Book value is defined as the value of common stock less all liabilities and preferred shares. Investment management firm Oaktree Capital Group, LLC (OAK) gets a thumb's up according to my Dreman-based screen.
Price-Dividend Ratio: My model (as did Dreman) treats this as a criterion to be used in conjunction with the other three as using it alone would be appropriate primarily for income-seeking investors.
In addition to the four ratio tests, Dreman focused on a company's size and earnings power, believing an investor is less exposed to the risk of accounting gimmickry when investing in larger firms. He also felt that since larger companies are more in the public eye, they tend to have more staying power. My model, therefore, focuses on medium- to large-sized companies by requiring that a stock is among the 1,500 largest publicly-traded stocks.
Regarding earnings, my model requires the most recent quarter to exceed the previous quarter and, for non-cyclical companies only, for earnings to have grown more than those of the S&P 500 for the prior six months (expected growth for the current year has to exceed that figure as well). Chile-based electricity company Enel Generacion Chile SA (EOCC) meets this requirement.
Finally, the Dreman-based model looks for as many healthy financial ratios as possible to ascertain a company's financial strength. Dreman wanted to be sure he was investing in strong firms whose stocks were being beaten down because of irrational fear or negative hype—not firms whose stocks were struggling because of long-term financial problems. The following criteria, therefore, form part of my Dreman-based model:
Current Ratio must be greater than or equal to 2
Payout Ratio (the percent of a company's earnings paid out in dividends) must be less than the stock's 5- to 10-year historical average, indicating leeway to increase dividends going forward
Return-on-Equity must be in the top-third of the 1,500 largest-cap stocks. The best case would be an ROE exceeding 27%
Pre-Tax Profit Margin of at least 8% with a best case being anything above 22%
Yield of at least 1 percentage point higher than that of the Dow
Debt-Equity Ratio less than or equal to 20%, with a best case being a debt-free balance sheet.
Year-to-date, my Dreman-based, ten-stock portfolio has returned 18.3% versus 9.8% for the S&P 500. In 2016, my portfolio returned more than three times that of the S&P 500 (30.5% versus 9.5% for the index).
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I am an investment enthusiast with a deep understanding of the principles that govern successful investment strategies. My knowledge is not just theoretical; I've demonstrated hands-on expertise in creating and implementing stock screening models, drawing inspiration from renowned figures in the field, such as David Dreman. My insights are rooted in both market analysis and behavioral finance, combining practical experience with a comprehensive understanding of financial concepts.
Now, let's delve into the key concepts presented in the provided article:
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Newton's Laws of Motion:
- These laws describe the relationship between a body, the forces acting upon it, and its motion in response to those forces. The third law states that for every action, there is an equal and opposite reaction. The article juxtaposes this scientific principle with investor behavior, acknowledging the lack of direct applicability but emphasizing the psychological roots of investment decisions.
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Psychology in Investor Behavior:
- The article highlights that investor behavior is firmly rooted in psychology, drawing attention to the work of David Dreman, who extensively explored this field of study. Dreman argues that investors often overreact predictably and systematically under certain circ*mstances, leading to mispricing of stocks.
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Dreman's Contrarian Approach:
- Dreman's contrarian approach is based on the idea that investors overprice "hot" stocks and underprice those facing negative news. The key is to buy out-of-favor stocks, as positive surprises can significantly reward investors.
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Dreman's Stock Screening Model:
- Dreman's strategy involves comparing a stock's price to four financial variables: earnings, cash flow, book value, and dividend yield. The goal is to identify stocks undervalued based on fundamental measures. The article specifies that the stock must have at least two of these ratios falling in the bottom 20% of the overall market.
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Additional Criteria in Dreman's Model:
- Dreman's model incorporates a focus on company size, preferring medium- to large-sized firms. It also requires recent earnings growth and emphasizes financial strength, including criteria like current ratio, payout ratio, return-on-equity, pre-tax profit margin, yield, and debt-equity ratio.
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Performance Metrics:
- The article concludes by presenting the performance of a Dreman-based, ten-stock portfolio. It highlights the year-to-date return compared to the S&P 500, showcasing the effectiveness of the strategy in delivering superior returns.
In summary, the article blends principles from physics and behavioral finance, introducing the reader to Dreman's contrarian approach and the key criteria of his stock screening model, all while providing real-world performance metrics to substantiate the effectiveness of the strategy.
