David Dreman Investment Philosophy

  • Contrarian Investing
  • 08 May 2019
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David Dreman

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.