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David Dreman summarized his investment
philosophy as the following:
Psychological biases tend to interfere
with sound investment decisions, but investors who understand these biases
can prevent them from affecting their own judgment and can profit from the
biases in others.
To prevent the biases from affecting
your own decisions:
Don’t be influenced by a hot
performance record. Don’t rely solely on the specific situation,
but take into account prior probabilities of similar situations. Don’t
be seduced by recent rates of investment return for individual stocks when
they deviate sharply from past norms; use long-term stock
characteristics. Don’t expect the strategy you adopt to prove a
quick success To profit from the biases of others: Favor stocks that are
out-of-favor with the market as indicated by low price- earnings ratios.
Universe of stocks Large and medium-sized companies, which offer a level
of stability and staying power.
Criteria for initial consideration:
Buy low price-earnings ratio stocks:
those that are among the bottom 40% of stocks ranked by price-earnings
ratio and have ratios below that of the S&P 500. Hold equal amounts of
15 to 20 stocks that are in 10 to 12 different industries for
diversification.
Secondary factors
The stock should provide a high dividend
yield that can be maintained or, preferably, raised. The company should
have a strong financial position: high ratios of current assets relative
to current liabilities; low debt as a percentage of equity; and low payout
ratios (dividends per share divided by earnings per share). The company
should have favorable operating conditions, such as high returns on equity
and high pretax profit margins relative to others in the industry. The
company should have a higher rate of earnings growth than the S&P 500
both in the recent past and projected one year down the road. In assessing
earnings growth, make sure to understand a company’s main line of
business, its components, and which components add the most. When
making an assessment of the general direction of earnings, use
conservative earnings estimates. For "high-rollers": Buy stocks
that show a loss, but be sure of a company’s financial strength, and
that the company’s assessment of the reason for the loss is sound, and
it is taking steps to fix the problem. In addition, use only a small
portion of your portfolio for this strategy. Stock monitoring and when to
sell
Portfolios should contain at least 12 to
15 stocks for adequate diversification, but portfolios should be kept to a
manageable size. Stocks should be sold when their price-earnings ratios
approach that of the overall market, regardless of how favorable prospects
look. However, stocks that reach high ratios solely because of an earnings
decline should not be sold, since the price drop is likely an overreaction
to the earnings decline. When stocks are sold, they should be replaced
with low price-earnings ratio stocks. You can substitute better stocks for
ones you already own, but do so selectively and avoid overtrading. Use a
two-year holding period as a test to weed out stocks that aren’t going
anywhere: If a stock has not done as well as the overall market over the
two-year time period, sell it and replace it. Sell a stock if you
see management behaving badly or acting only in its own self- interest.
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