Boganmeldelse af David Dremans "Contrarian Investment Strategies"

Book Summary

Contrarian Investment Strategies: The Next Generation

September 17, 2017

This post is also available in: Dansk

Abstract

  • The author, David Dreman, refers to a SEC report to prove that the “experts” do one thing perfectly: they buy and sell on the worst of times. Hence, David recommends you ditch your financial manager and instead hire a blindfolded, margarita drinking chimpanzee.
  • Rather than acquiring the popular glamour stocks, you should be the contrarian fish that swims against the current. An array of studies show that low P/E, P/CF and P/BV stocks outcompete the glamour stocks. The basic reason is that popular, mainstream stock picks must outperform; positive surprises do not impact the stock price greatly, since these expectations are already baked into the price. On the contrary, the undervalued stocks’ prices are already slammed to the ground. They are thus relatively immune to bad news, whereas good news is often met with handsome price increases.
  • A buying decision should scream to you, whereas selling is a far more difficult decision. David provides you with a few tips on how to approach such decisions.

Contrarian Investment Strategies is a strong all-around book that e.g. discusses the “experts'” incompetence, the most important fundamental metrics when it comes to stock-picking, market-beating value strategies, the dangers of prediction, mass psychology and irrationality in the stock market sphere, investing in crisis situations, the risk term, and the many pitfalls facing investors. I’ll try to highlight my key take-aways, but I strongly recommend picking it up yourself – great book.

Why a blindfolded, margarita-drinking chimpanzee should be your financial manager
The classic argument for handing over the reins of your portfolio to an “expert” is that they have access to more information, which alongside their experience, knowledge and skills enable them to do what all investors dream of: buy low, sell high. However, a report from the Securities and Exchange Commission (SEC) portrays a different reality. The individual investors buy at market bottoms and sell when the markets are overheated whereas the institutional investors do the exact opposite. Desperation and panic characterize the “experts” who are worried about their job safety and hence don’t dare to go against the “expert consensus” (maybe there’s some truth in Nassim Taleb’s ’empty suits’ metaphor?)

The “experts” do some things perfectly, though. David proves that their forecasts for the future are almost always perfectly wrong. The complete opposite of their prophecies are often what plays out. Hence, David explains that these experts are extremely skilled at being wrong. However, maybe it’s not their skills that are rotten, but rather the system. David explains that analysts’ bonuses are based on how many buy recommendations they produce. Furthermore, analysts are often blacklisted from receiving information from companies that they have granted a sell recommendation. Hence, in order not to be excluded the analysts don’t dare not to put a buy recommendation on the majority of securities. For these reasons, there are 7 times as many buy recommendations than there are sell recommendations.

In addition, based on historical numbers, the chances of an analyst to predict earnings estimate within a 5% span 4 quarters in a row is 1 to 130. Increase that streak to 10 quarters in a row, and your chances are 1 to 200,000. 20 quarters? 1 to 50,000,000,000 (50 billion!). Actually, a study found that analysts’ estimates of future earnings were wrong 66-75% of the time. Another study ascertained that in 90% of all industries, the analysts’ consensus were more than 20% off the mark. It’s not without reason or empirical evidence that David claims you would be better off if a blindfolded chimpanzee sipping margaritas handled your finances rather than the “experts”.

Be the contrarian fish who swims upstream
The previous section was a long run-up to the message: Forget the experts! Their opinions and recommendations should be regarded as noise. The stocks that they recommend are always extrapolated and overvalued. They’re interested in putting money in their employers’ pockets, not yours.

“Well, what then?”, you may ask. You got to be a contrarian. You must swim against the current, disregard the media noise and construct your own portfolio based on healthy, contrarian principles. Rather than focusing on glamour stocks, you should be on the look-out for the neglected, the taunted, the unpopular and the beaten – the bottom of the barrel. An ocean of studies prove that the quintiles with the lowest price-to-fundamentals (e.g. P/E, P/CF and P/BV) outmatch the market, and especially the glamour stocks. The basic reason is that popular, mainstream stock picks must outperform; positive surprises do not impact the stock price greatly, since these expectations are already baked into the price. On the contrary, the undervalued stocks’ prices are already slammed to the ground. They are thus relatively immune to bad news, whereas good news is often met with handsome price increases. Two independent studies of two different time periods demonstrated that if you simply chose a basket of stocks with the lowest P/E, you would gain an average return of 16-18.4% annually while the glamour stocks would increase your wealth with just 3-7%. Intrigued? There are a lot more of such examples in Deep Value.

Simple, but effective strategies
David presents four ‘strategies’ (in reality, it’s just some very simple selection/screening criteria) that workload-wise are characterised by low intensity, but achieve high-intensity results. The historically best performing ‘strategy’ has been to buy a basket of the 30 lowest P/E stocks within 15 industries where each stock is sold when its P/E reaches the industry or market average. P/CF, P/BV and lastly P/D follow suit in terms of gains.

If you’re not comfortable with such a ‘mechanic’ approach to constructing your portfolio and instead prefer to know the stocks you own, you would venture into analyses of each security. Though David doesn’t exactly recommend doing so, he supplies the reader with a few indicators that might be valuable to take a look at:

  • Does the company have a strong financial position? Does its current assets exceed the current liabilities? How’s the balancing of debt to assets?
  • Is the earnings growth above that of the S&P500 average? Is it likely that this growth rate will continue, rise or stagnate?
  • Is there an above average dividend yield, which can be sustained or increased over time?

These qualities can be rare in the contrarian stock sphere. But those that possess them may be a GARP stock (growth at a reasonable price). They are often found in industries that are hit by a cyclical downturn, but where the company’s position continues to be strong.

The art of selling
It’s a giant headache to sell a stock. The fear of selling too early is intense; haven’t we all tried selling a stock only to see it rise like a rocket afterwards? Selling also causes another ‘problem’: where should one place these funds? Currently, interest rates on saving accounts are bascially nill and government bond yields are laughable. I believe many feel ‘forced’ to buy stocks despite knowing that the market is (at least compared to historical levels) overvalued with a Shiller P/E of +30 (read Irrational Exuberance for an explanation of this term).

The buy decision is easy. The stock should scream “buy me!” The sell decision doesn’t speak to you in the same manner. David recommends you sell when the fundamental metric that justified the buy decision, reaches the market/industry average. If you for instance bought a stock based on a P/E of 12 relative to a industry average of 20, one should realize the profits when the stock’s price increases to the same level. This should be done regardless of how favorable you consider the company’s outlook. Generally, it’s better to replace it with another contrarian stock. David recommends that you pack away your stubbornness and greed. Realize profits, forget the stock, and start hunting for the next opportunity.

As mentioned in the introduction, this book is packed with words of wisdom. In fact, David presents 41 rules that can help guide the investor. It’s of course a bit of a mouthful, making it impossible to remember all. But if the book convinces you that the “experts” are nothing but noise and that contrarian bets have had tremendous success, you have understood the essence of Contrarian Investment Strategies.

This post is also available in: Dansk

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