Contrarian strategy: 10 hidden gems

by John Reese, editor Validea

The most successful gurus I follow share one striking similarity: they are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig.

One in particular is known for being, well, the most contrarian: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems.

His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services.

Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in beaten-up stocks.

Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- that everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague.

In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products.

And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.

By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.

Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield.

If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't paying it much attention.

And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)

But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies.

What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry.

To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8%), and the debt/equity ratio (which should be below the industry average, or below 20%).

By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.

Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. This type of contrarian approach isn't for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they've been overlooking.

And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market.

The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.

But, as fears abated and the crisis passed, investors began to recognize the strong stocks they'd been shunning. And the Dreman portfolio reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and 23.1% in 2010 (vs. 12.8% for the S&P).

It has struggled in 2011, but remains far ahead of the broader market over the long haul. Since its July 2003 inception, the 10-stock Dreman-based portfolio has returned 67.7%, or 6.3% annualized, vs. 26.0%, or just 2.8%, for the S&P (through Dec. 7).

As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Right now, its holdings include some very unloved firms, with a major tilt toward international stocks.

Here's the full list of its current holdings:

AstraZeneca PLC (AZN)
BP PLC (BP)
Petroleo Brasileiro SA (PBR)
Southern Copper Corporation (SCCO)
Assured Guaranty Ltd. (AGO)
Total S.A. (TOT)
Telecom Argentina S.A. (TEO)
Eni S.p.A. (E)
Triangle Capital Corporation (TCAP)
Banco Macro SA (BMA)

Learn more about this financial newsletter at John Reese's Validea.