Steve Forbes Interview: David Dreman, Contrarian Investor, Pt. 1 ?

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Dreman: Well, contrarian is a form of value investor, where we tend to buy the lowest P/E stocks, or by P/E ratio, or we can also use price-to-book, or price-to-cash flow or even high yield.

There have been studies that go back now as far as the 1930s, and they show that low P/E and low price-to-book have outperformed the market in every decade since, I think, starting with the 1940s.

So it does work. There are a lot of very good stocks that tend to be – people just don’t like them for one reason or another, and they won’t pay much for them. Classic examples were the food companies 20 years ago, or the tobacco companies in the 1990s. You get whole industries – oil and gas – that were very, very, out of favor for many, many years that really had solid growth, strong fundamentals, strong finances, really excellent cash flow and high yields.

So that’s basically the type of stocks we buy. We always have a diversified portfolio, probably 50 to 60 stocks, because we’ll miss something. Everybody’s going to miss some. I think Warren Buffet said, “If you can pick 60%, you’re doing very, very well,” and I think that’s very true.

We have diversification and we don’t take really big bets on any one stock. We try to keep the size of each purchase pretty much the same. If we buy a new company, a new name, we’ll sell another one. We always sell at the market multiple, we buy below market multiple.

But when a stock moves up to the market multiple, we’ll sell it. Or if there’s very bad news, which occasionally happens, we sell immediately. But overall, the strategy has worked well. Unfortunately, it doesn’t work all the time. It’s going to have its bad years, and then some very good ones.

Forbes: So what new metrics and new measures do you have in the book to help you find these contrarian equities?

Dreman: A couple that were always there and we hadn’t used. I guess the most important would be the fact that if a company has a loss, even if we think it’s a short-term loss, we’ll sell it and buy it when the company comes back to profitability. That would have saved a lot of us in the financial crisis, because everybody thought those losses would have been very, very short-term, but they weren’t. So that’s probably important.

Diversification is more important than it’s ever been because we are actually putting our portfolios up to, as I said, 50 or 60 stocks. We actually put together a low P/E index fund, if you will, which is all low P/E stocks. We will have 100, and they’re equally weighted. That’s done reasonably well over time.

Forbes: Now, this index, is it just big-cap, small-cap, a mix? How do you put the mix? And it’s done just numerically? So if a stock doubles, it’s still the same weight as another stock? You don’t do it by capitalization or market value?

Dreman: Actually we have a slew of very low P/E funds. We have small-cap, mid-cap, what they call “smid,” which is small and mid put together, and large-cap. Those are probably our four big ones. And it turns out, over time, that low P/E small-cap has really outperformed everything around, if you go long enough. But there will be periods that could go up to five years or eight years, where it –

Forbes: And small-cap, by your definition, is what?

Dreman: Well, the definition has probably changed very dramatically since 2008. Small-cap was $2 billion in 2008. I think it’s probably around $1.4 billion or $1.5 billion right now. And large-cap has come down from $20 billion to probably $10 billion because the market has really gone down pretty significantly.

Forbes: So among the new measures you say is if you have a loss, just to cut it.

Dreman: Right.

Forbes: In terms of profit. What other ones do you like?

source: forbes.com

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