Your Ultimate Guide to David Dreman Investing

This article on David Dreman 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 JanBaby, edited by Broken Leg Investing.

When you search the word contrarian in the dictionary, a high-quality image of David Dreman should display prominently beside the definition. If your dictionary is flawed and does not have his portrait, then you should at least have his description — a person who opposes or rejects popular opinion, especially in stock exchange dealing.

Whether you prefer to label David Dreman as the dean, founding father, or pioneer of contrarian investing, you’d be correct. Dreman has written five books, four of which have the words contrarian investment in the title. He has been a senior columnist with Forbes for over 30 years and has written for The New York Times, The Wall Street Journal, Fortunes, and Barron’s.

If Dreman needs another point in his favour , then note that his investment firm — Dreman Value Management, LLC. — has on average beaten the market since its inception in 1977. David Dreman knows how to play the stock market.

What is Dreman’s approach to investing? How does he value companies? What is Dreman’s definition of risk? Does he has any book recommendations for the individual investor? Let’s find out!

David Dreman’s Early Life

David Dreman was born on the first day of 1936 in Winnipeg, Manitoba, Canada. Investing was in his blood, as his father — Joseph Dreman — traded commodities for a living. This positive influence in his life fueled Dreman’s interest in the markets. He studied at the University of Manitoba and then worked for the brokerage firm Rauscher Pierce Refsnes Securities Corp.

In the late 1960s, Dreman packed his bags and moved to New York for a year to study the American markets. As Dreman discovered, this was only the start of a long journey ahead.

“That year turned into another almost 50 years. I’ve lived in New York for quite some time, at least 20 years or more … I came here and one of the first things I experienced was the go-go bubble of the '60s. I worked at Value Line at the time, and we thought were going to make millions; we thought it would never end. Being young, you thought it was easy to make money, but the people around us who were more experienced in bubbles knew we were going to get hurt. They were right. My friends pretty much lost their profits; I was a little luckier because I remembered some of my Graham and Dodd. When the markets went down, I got hurt, but I still came out with some money.”

Dreman describes himself as getting a little lucky during the go-go bubble stock market crash. Although he did implement some teachings provided by Benjamin Graham and David Dodd, this was not enough. He revealed this experience led him to lose 75% of his net worth. With such a significant impact, it must have been difficult for him to trust the stock market.

Dreman continued on his journey, but not without making some changes to his investment approach. These changes — such as becoming contrarian — would eventually lead Dreman to being the remarkable investor he is today.

David Dreman On Investing

If you don’t already know, David Dreman likes contrarian investing. However, the strategy could have a broad range of interpretations. Being contrarian simply means to believe and follow an investment approach that is different from the majority. Dreman’s application of contrarian investing is a form of value investing, meaning that he considers markets irrational and believes there is difference between a company’s stock price and its overall value. The reason this belief is considered contrarian — different than the rest — is because of the popular efficient market hypothesis (EMH).

“Markets, they said, are efficient. That meant that stock prices are determined by the thorough and diligent work of the brightest analysts, money managers, and other investors … The hypothesis has been so widely accepted in academic circles and on Wall Street that several of its leading proponents have received Nobel Prizes for their contributions.”

If you want to achieve market-beating returns, the first step is to become a contrarian. However, the idea of ignoring award-winning academics is easier said than done. Some may even wonder — if David Dreman’s contrarian strategy is so effective, why doesn’t everyone do it? Thankfully, the contrarian himself provides us with some insight:

“It is not enough to have winning methods, we must be able to use them. It sounds almost simplistic, but it isn’t. Sure, the methods are easy to understand and initiate. But most investors, whether professional or individual, even with the best intentions cannot follow through.”

This is almost too good to be true. Not only will Dreman’s methods beat the market, but they are easy to understand and initiate. The only challenging part is following through and trusting the strategy. Dreman first began sharing his simple investment strategy over 40 years ago, yet even today they are still considered contrarian. It would be safe to assume Dreman has no problem ignoring the academic circles.

David Dreman On Market Psychology

If everyone began to follow Dreman’s strategy, it would simply stop working. However, Dreman is very confident that will never happen. His confidence stems from many years of studying the single factor that controls the markets — investor psychology.

“Without understanding investor psychology and how it affects us all, contrarian strategies are unlikely to be successfully utilized. This is the reason why most people cannot use these strategies even though they are known to have provided superior results for years.”

Many books and studies have been published on investor psychology. This includes Contrarian Investment Strategies: The Psychological Edge, Dreman’s most recent book. Although researchers’ opinions may vary slightly, they all come to the same basic conclusion — every investor will be affected by psychological forces. Often called biases or heuristics, these forces often lead investors in the wrong direction.

“... there is a body of research conducted by outstanding psychologists in recent decades that provides us with patterns of predictable investor errors. These errors are so systematic that the knowledgeable investor can take advantage of them. It is upon this behaviour that my contrarian strategies are founded.”

We are all susceptible to multiple biases or errors. It is important for contrarians to educate themselves on investor psychology. As Dreman notes, these errors are so systematic that even being aware of them will give an investor an advantage.  

David Dreman On Technical Analysis

Along with EMH, Dreman also has scrutinized another popular investment approach called technical analysis. Using a pattern of lines and indicators, investors try to use a stock’s historic price charts to predict the future. Dreman believes these investors fall for a psychological bias by attempting to achieve the impossible.

“A good many researchers tested the proposition that stocks move in discernible trends … All studies demonstrated that future price movements cannot be predicted from past changes. Without exception, the findings indicated randomness in price — day to day, week to week, even month to month … No matter how convinced the technician is about the market’s or a stock’s next move, he has no more chance of being right than by tossing a coin … Do not use market-timing or technical analysis. These techniques can only cost you money.”

The error is rather obvious once David Dreman make us aware of it. Those who have tried technical analysis may feel foolish. They somehow believe that by drawing some lines on a chart or backtesting an indicator, they have created a crystal ball to predict the future. No person or computer knows what will happen next in the markets.

How David Dreman Values Stocks

David Dreman does not use technical analysis to pick winning stocks. He uses the opposite — fundamental analysis. He has proven that every company has key ratios that can be calculated to find stocks with the highest chance of success.

“Our firm is finding we’ve always had somewhat better results with low P/E portfolios, or low price-to-book portfolios. But low price-to-book, low price-to-cash flow and low P/E have always outperformed the market enormously over 10, 15 and 20 years.”

The basics for Dreman’s strategy really are simple and easy to understand. Start by screening for companies with low price-to-earnings, low price-to-book, and low price-to-cash flow. Dreman has found that over time, these companies have a higher probability of increased performance.

“The low-P/E strategy is somewhat more rewarding, returning 19.0% annually for the 27 years of the study vs. 18.8% for low price-to-book value and 18.0% for the low price-to-cash flow. But all three strategies handily beat the market and sharply outperform the best stock in each case.”

For those who have extra time on their hands and want to evaluate companies further, Dreman provides five more pieces of criteria. These characteristics have been found in companies that have outperformed over time.

“Indicator 1. A strong financial position Indicator 2. As many favorable operating and financial ratios as possible Indicator 3. A higher rate of earnings growth than the S&P 500 in the immediate past Indicator 4. Earnings estimates should always lean to the conservative side Indicator 5. An above-average dividend yield, which the company can sustain”

Once you have screened out the most favourable companies, Dreman recommends building a portfolio of 20 to 30 stocks. Sell after a minimum of 1 year and a maximum of 3 years depending on the stock’s performance.

David Dreman on Risk

Some investors may begin to wonder how risky a portfolio of 20 to 30 stocks with strong value indicators is. Unfortunately, one can interpret this question many different ways. The investing world regularly debates the definition of risk. Most investors would define it as the amount of volatility or movement in the stock’s price. Dreman’s findings prove otherwise.

“Whether unrealistic or not, an entire generation has been trained to believe risk is volatility ... Possibly you accept these measures without question. Most people do. But in truth they are faulty. In the first place it has been known for decades that there is no correlation between risk, as the academics define it, and return. Higher volatility does not give better results, nor low volatility worse.”

It should come as no surprise to learn that David Dreman has a contrarian perspective on risk. His concerns are legitimate, as many other researchers have found zero correlation between risk and return. As Dreman explains, a definition of risk must incorporate two key factors.

“The probability that the investment you chose will preserve your capital over the time you intend to invest your funds.The probability the investments you select will outperform alternative investments for this period.”

Using Dreman’s perspective, you’ll realize our value portfolio carries little risk. With the high returns the portfolio will produce, it is unlikely any alternative investments will outperform. As long as you’re willing to commit to the strategy for 10 years or more, the portfolio should be worry-free.

David Dreman’s Book Recommendations

Every great investor has an addiction for reading books. When one of these investors provides a recommendation, it’s a good idea to take note. Fortunately, Dreman provided some suggestions for an individual investor.

Number one, first published in 1949, is The Intelligent Investor by Benjamin Graham. Following close behind is one of Dreman’s own books, Contrarian Investment Strategies: The Psychological Edge. Two more include Liar’s Poker by Michael Lewis and Extraordinary Popular Delusions & the Madness of Crowds by Charles MacKay.

A Final Thought On David Dreman

Many investors don’t consider David Dreman in the same class as Warren Buffett or Benjamin Graham, but he deserves to be. He has hidden in the shadows from the majority of the investing world, but those who decided to recognize Dreman and learn from his teachings greatly improved their investment strategy.

We value investors are so fortunate to learn from Dreman and his experiences. It is not often that such a successful professional is willing to share their secrets. It is because of Dreman’s willingness to challenge the experts and academics that we are able to achieve extraordinary returns.

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