Contrarian Investing Strategy? Expect Big Upside Without The Downside

This article on contrarian investing strategy was written by Colin Richardson. Colin is a private investor based in Alberta, Canada. He focuses on applying a quantitative strategy to eliminate behavioral biases in his personal account. Article image (Creative Commons) by SplitShire, edited by The Broken Leg.

It’s no surprise that David Dreman follows a contrarian investing strategy. He has published four books on the approach and continues to be a major advocate for buying out-of-favor stocks. However, some may wonder why Dreman prefers to buy shares of lousy, unwanted companies. Why does he recommend isolating yourself from the majority of stock investors? What does Dreman know that the rest of us don’t?

Within his book Contrarian Investment Strategies: The Next Generation, Dreman describes a study conducted to determine the impact surprises have on a company’s stock price. The findings may provide us a reason why Dreman likes the contrarian investing strategy.

Contrarian Investing Strategy: A Path To Making Money In The Stock Market

Using the period from 1973-1996, he set out in his book to determine the impact surprise announcements have on the stock price of favored and unfavored companies. Using the Price/Earnings (P/E), Price/Cash Flow (P/CF), and Price/Book Value (P/BV) metrics, he categorized the favored stocks as having high multiples and unfavored as having low.

The Securities and Exchange Commission (SEC) requires companies to report earnings on a quarterly basis. This often leads to stock analysts releasing their profitability estimates before the announcement. Unfortunately, these estimates have a tendency to be wrong, leading investors to be surprised and react by either buying or selling the stock.

“What is remarkable is not only that out-of-favor stocks outperform by all three measures, but how similar the performance is regardless of the value measure we choose. We thus begin to see a path to making money in the stock market. Earnings surprises, whether positive or negative, affect favored and out-of-favor stocks very differently. Surprise consistently results in above-average performance for out-of-favor stocks and below-average performance for favored stocks … Conversely, buying favorites and being exposed to the frequent surprises will cost you money.”

Unfavored stocks have actually shown to benefit from the inaccuracy of stock analyst forecasts. We begin to see a reason for Dreman’s contrarian investing strategy. With stock analysts having such a high degree of error, an investor could profit from purchasing companies with low P/E, low P/CF, or low P/BV immediately before the earnings announcement. As Dreman also notes, simply avoiding companies with high price multiples greatly reduces the amount of loss.

Sit Up And Take Notice

Dreman’s findings show an increase in performance when unfavored stocks are presented with a surprise. However, there can be two types of surprises — positive or negative. An investor may begin to question how stocks react to positive news. Could an investor benefit from buying favored stocks when earnings estimates are realistic and achievable?

“Positive Surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites … Since analysts and investors alike believe that they can precisely judge which stocks will be the real winners in the years ahead, a positive surprise does little more than confirm their expectations. It’s no great shakes — the top companies should have rapidly growing revenues, market share, and earnings. By the end of the year, therefore, the effect of the surprise almost disappears. Investors react differently to positive surprises for out-of-favor companies, however, no matter which of the three value yardsticks by which we measure them. Investors put these stocks into the lowest category precisely because they expect them to continue to mope … A positive earnings surprise for a stock in this group is an event. Investors sit up and take notice.”

Dreman considered a positive surprise as any announcement where the stock analysts underestimated the gain or overestimated the loss. A company may have been unprofitable in the quarter but if stock analysts predicted an even greater loss, investors are assumed to be positively surprised.

One of the potential reasons for Dreman’s findings is a psychological bias called narrative fallacy. As investors, we tend to prefer buying stocks in companies with feel-good stories. Let's consider an out-of-favor stock to be Rocky Balboa, making the stock analysts Apollo Creed. When Rocky is able to overcome Apollo or the underdog company can prove the experts wrong, investors appreciate the story. By doing so, they rush to buy the stock, forcing its price upwards. However, when a favored company continues to provide positive results, the story is overlooked. Using a contrarian investing strategy will give you confidence when buying the Rocky Balboa stocks.

Water Off A Duck’s Back

With positive surprises resulting in a major improvement in unfavored stocks, we may begin to wonder if a similar degree of impact would occur during negative surprises. Should we avoid unfavored companies with a higher likelihood of announcing negative news?

“Negative surprises are like water off a duck’s back for this group (out-of-favor stocks). Investors have low expectations for what they consider lackluster or bad stocks, and when they do disappoint, few eyebrows are raised. The bottom line is that a negative surprise is not much of an event in the surprise quarter and is a non-event in the nine months following the news. Consider the ‘best’ companies, however. Investors expect only glowing prospects for these stocks. After all, they confidently — over confidently — believe that they can divine the future of a ‘good’ stock with precision. These stocks are not supposed to disappoint; people pay top dollar for them for exactly this reason. So when the negative surprise arrives, the results are devastating.”

The findings leave little doubt why Dreman follows a contrarian investing strategy. When favored companies fail to fulfill expectations, investors panic, resulting in a large drop in performance. However, when out-of-favor stocks fail, no one is really taken back and the stock limps along as normal.

Lingering Effects 

As long as stock analysts continue to release their estimates, Dreman will continue to reap the benefits. Their inaccurate and skeptical predictions have been shown to do nothing but increase an unfavored stock’s performance. For those who fear the collapse of Wall Street and the loss of demand for earnings estimates, Dreman determined the effect of surprises over time.

“We have seen the results of surprise on best and worst stocks for up to one year after the surprise is announced. Are there lingering effects beyond that?... Let us look first at the two types of event triggers (good news on the ‘worst’ stocks and bad news on the ‘best’) ... The lowest P/E group showing positive earnings surprises (low P/E positive) outperforms the market in all 20 quarters after the surprises, and records an above-market return of 34.7% for the five-year period. Conversely, the highest P/E group receiving negative surprises (high P/E negative) underperforms in every quarter for the following five years, lagging the market by 44.7% for the full period. As we can see, the differential between these two groups continues to increase significantly through the five years measured. Is the entire difference in performance between the two types of event triggers caused by earnings surprises? Did the original surprises change investor perceptions permanently? These questions are impossible to answer statistically at this time. We do know that investors were far too confident of their prognostications for both ‘best’ and ‘worst’ stocks, which led to best stocks being significantly overvalued and worst stocks being undervalued … Not one but a series of surprises, other than analysts’ forecast errors, that continue to reinforce the price revaluations.”

Dreman’s findings show a lasting impact on stock performance up to five years after the surprise. We can’t tell if this is a direct correlation between the performance and the surprise, or some other reason intervenes. Nevertheless, the benefits of purchasing unfavored stocks are obvious.

At The Broken Leg, we love investing in companies with some sort of catalyst attached. This may include analysts overestimating the earnings, an activist attempting to acquire the company, or the announcement of a share buyback program. Dreman’s study is only one of many to find an increase in a stock’s performance after a positive announcement.

We now know one of the many reasons why Dreman likes a contrarian investing strategy. He simply uses experts and their failed projections to his benefit. Understanding Dreman’s contrarian investing strategy is your path to worry-free investing.

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