A very good friend of mine sent me this book, because he found it to be a terrific investment resource. After reading the book, I fully agree with my friend that Mr. Dreman has some wonderful tips on investing.
Mr. Dreman’s fund Kemper-Dreman High Return fund has shown superior results since its founding in 1988. In fact, it was the number one equity-income fund among all 208 ranked by Lipper Analytical Services, Inc. Mr. Dreman is one of a handful of managers who has beaten the runaway market over the past five, ten, and fifteen years.
What is the essence of Mr. Dreman’s investment thesis?
In essence, Mr. Dreman believes in purchasing out of favor high quality companies. That is, Mr. Dreman believes that the market overreacts to good and bad news. Thus, if one is patient, and has fortitude, one should purchase the equity of companies that are suffering from temporary setbacks. A good example is Philip Morris, now called Atria. Philip Morris, the world’s leading cigarette company, had spectacular stock performance from the 1950’s until the mid 1990’s despite the surgeon general’s warning against smoking. However, starting in the 1990’s litigants successfully defeated the cigarette companies, leading to billions of dollars in penalties. Over the next few years, Philip Morris stock dropped precipitously because of fears that on-going litigation would lead to bankruptcy similar to the fate of asbestos companies. However, investors failed to recognize a significant difference. That is, state governments were very dependent upon the sales tax of cigarettes to fund their operations. Thus, despite the saber rattling, politicians were prepared to make significant compromises to keep the cigarette companies viable. Stated differently, while Philip Morris has on-going payment liabilities, the settlements provided the company with significant cash flow to not only keep up their current operations, but purchase other companies. In essence, contrarian investors have made a fortune purchasing Philip Morris at discount prices.
In a nutshell, if you buy a stock that is worth $100 for $50, then you have a chance to double your money once the market recognizes again the legitimate value of the stock. If the company continues to earn money and its book value and earnings per share increase to justify a $130 price, then possibly over time you will make $80. In essence, contrarian investors believe that if one is patient that at some point, the market will recognize the fair value of your acquisition and you will then profit dramatically.
The key to successful contrarian investment is that the investor must have absolute confidence in the correctness of his vision. He must be prepared to do his own internal research, and intellectually disdain the prevalent negative research that is bombarding the stock. Frankly, Wall Street with its concise executive summaries and beautiful charts frequently lack investigative reporting expertise. A number of years ago, when Mexico was suffering one of its periodic downdrafts, I tried to find cheap stocks such as oil companies where you could purchase the proven reserves at a major discount to the prices that American oil companies sold for. I was shocked at the paucity of information available. Moreover, the “so-called” experts were junior analysts whose only expertise was their knowledge of Spanish. The Russian oil company Gazprom is a great example of a contrarian bet. By purchasing Gazprom, one is acquiring barrels of oil at a fraction of both the world price for oil and a fraction of the price available from purchasing EXXON.
Why do not more people buy contrarian bets?
In part, Wall Street puts tremendous emphasis on short term results. That is, a portfolio manager cannot buy the stock of a company that is out of favor if he feels that it will take let us say 12-15 months for the market to react positively. The greater the delays in the expected turn around period, the greater the discount on the stock. Stated differently a very long work out period reduces the potential purchasers dramatically, leading to even greater discounts from fair value. The late Larry Tisch made a fortune buying tankers for below scrap value when there was an overcapacity in shipping. When the market tightened up, he was able to charge significant freight rates, and ultimately sold his tanker fleet for an enormous profit.
In part, psychologically it is extremely difficult to swim against the tide. On a personal basis, I worked with Mike Steinhardt, a great contrarian investor for five years. However, the internal stresses on Mike during the down periods turned him into a human volcano who would literally yell so loud that the walls would shake. While I was no shrinking violet, breaking hundreds of phones during my trading career, I was bland Melba toast compared to Mike. In the end, Mike either had to close his fund or risk a serious heart attack.
In part, holding a losing position is the equivalent of Chinese Water torture. Every day the water keeps dripping on your forehead, until you get a splitting headache. The quick solution is just to liquidate the position. Unfortunately, you might be selling right before the turnaround.
What helps a contrarian maintain his losing position?
If the asset provides a dividend or cash flow, the pain is bearable. However, stocks or gold that has a holding cost become increasingly burdensome as Father Time keeps moving along.
What does Mr. Dreman not like?
Mr. Dreman discounts Wall Street research that lauds high quality companies that trade at steep price earnings ratios, because their elevated prices cannot sustain slowing growth rates. Thus, Coca Cola, a long-time favorite of the esteemed Warren Buffet has been a financial disappointment in recent years because it traded at too high a price. Moreover, to sustain Coca Cola’s earnings, the company forced their franchises to buy ever increasing quantities of Coca Cola. This tactic distorted the earnings of Coca Cola and obscured the reality of their operations in a mature market. Microsoft and Wal-Mart have been terrible stock performers in recent years. Their poor performance stems from the fact that their high valuation could not be sustained once their rate of profit increases slowed.
Mr. Dreman also dismisses technicians and market momentum investors. He feels that their success requires either reading arcane charts or “ride a rising tide.” In the long run, these practices are not sustainable and also lead to short term capital gains, which is very tax inefficient.
Mr. Dreman is not a believer in high quality U.S. Treasury bonds or Treasury Bills. He shows conclusively that after inflation and taxes, at best over extended periods of time, you are running in place owning fixed income securities.
Originally published in the Sarasota Herald-Tribune
