This article on David Dreman's 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 Broken Leg Investing.
If you have been a part of the Broken Leg Investing community for a while, you are likely familiar with David Dreman’s strategy. If not, imagine a method where it benefits the investor to ignore the experts and pick stocks without considering a highly calculated forecast. David Dreman’s strategy does just that by focusing on building a diversified portfolio around simple value metrics. As a core piece of his strategy, he suggests ignoring buy, sell, or hold indicators completely and using your own insight into the stock’s valuation to build a portfolio.
This shift in focus radically simplifies investment decision making. Investors interested in achieving great performance no longer have to worry about trying to beat the market by trying to predict the future direction of individual stocks. Even better, Dreman’s strategy has been found to lap the experts in terms of a portfolio’s annual growth rate.
But why does it work? Shouldn't returns be higher if we follow the opinions of experts? What's going on?
Table of Contents
Take Off The Rose-Colored Glasses
In 1969, David Dreman went to work as a junior analyst, where he was taught by the so-called Wall Street experts how to invest in the stock market. Unfortunately, in the ensuring years, he would end up losing 75% of his net worth attempting to implement their teaching. After electing to switch directions, going against the crowd, Dreman’s returns began to shift upwards. With decades of trumping the market, Dreman distilled everything he had learned into a great series of contrarian investing books.
Detailed within Contrarian Investment Strategies: The Next Generation, Dreman studied five expansion and four recession periods to determine an expert’s level of optimism throughout the cycle. At the end of the study, his conclusion was alarming:
"The statistical analysis demonstrates that economic conditions do not seem to magnify analyst errors. They are about the same in periods of expansion or recession as they are at other times. What did come out clearly is that analysts are always optimistic. Their forecasts are too optimistic in periods of recession, and this optimism doesn’t decrease in periods of economic recovery, or in more normal times. This last finding is not new. A number of research papers have been devoted to the subject of analyst optimism, and, with exception of one that used far too short a period of time, all have come up with the same conclusion. This is an important finding for the investor: if analysts are generally optimistic, there will be a large number of disappointments created not by events, but by initially seeing the company or industry through rose-colored glasses.”
Prior to the study, Dreman hypothesized that the majority of analysts’ estimates would be overly optimistic in periods of recession but then be under-optimistic in periods of expansion. However, he found analysts were actually over-optimistic at all stages of the business cycle.
Unfortunately, this over-optimism also leads to a high degree of error — being an optimist with our finances can be costly. History has proven that when stock prices go up, they almost always eventually drop. Analysts seem to be ignorant of the fact that only a very select few companies can resist this mean reversion. As Dreman noted, multiple studies, including his, have found that analysts are overly optimistic during times of expansion. As a result, their projections are wrong, turning the purchase into speculation. The study’s conclusion is a major support for David Dreman’s strategy to ignore expert projections.
Stop Aiming For The Bull’s Eye
This concept and realization may be difficult to swallow. How can someone whose paid career is to analyze and forecast a company's future be wrong so often? The individual investor might argue these experts must have exclusive services, tools, or knowledge that gives them an advantage. Dreman recognizes this concern and suggests that these experts are attempting to play a game where no one can truly win:
“We have found that analyst forecast errors have been unacceptably high for a long time, and they have gone up over the past two decades. An error rate of 44% is frightful — much too high to be used by money managers or individual investors for selecting stocks… Forecasting by industry was just as bad. Forecast errors averaged over 40%, with error rates almost indistinguishable between those industries with supposedly excellent visibility and those considered to have dull prospects… The size and frequency of the forecasting errors call into question many important methods of choosing stocks that rely on finely tuned estimates running years into the future… If the average forecast error is 44% annually, the chance of getting a bull’s eye at a distance of ten years seems extremely slim. Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.”
Although experts may have expensive resources to generate a projection, it appears they are attempting to achieve the impossible. Dreman suggests any valuation method requiring an estimate of growth is impossible to be calculated accurately. One of the faulty valuation methods referred to by Dreman is a discounted cash flow (DCF) calculation. Ultimately, the investor calculates an intrinsic value for the company’s stock, which can then be compared to the current stock price. However, this intrinsic value is heavily skewed by the projected growth rate.
Don’t Overlook The Findings
To help determine the importance of this projection, lets do a DCF calculation on a theoretical company. Ten years ago this company had $150M of free cash flow with 200 shares outstanding ($0.75/per share). It has grew at 15% up to the current year, making today’s free cash flow $2.64/ per share. We will use the commonly accepted 10% discount rate for the calculation. Let’s pretend we know for sure the company will continue to grow at 15% over the next ten years, making the correct intrinsic value $97. Unfortunately, we cannot predict the future and are forced to make a projection.
Dreman suggests only 1 in 4 analysts are able to correctly estimate the future fundamentals within five percentage points. If we are able to forecast better than a majority of analysts, 10% growth would present a $65 value, while 20% growth would present a $145 value. Even if we are part of the top percentile, we are still presented with a $80 spread to determine the correct intrinsic value. Lastly, let’s say we accidentally projected an error of 10% on either side of the current 15% growth rate. Then, 5% growth would present a $44 value and 25% growth would present a $215 value. Our more realistic margin of error now presents us with a $171 spread! This simple demonstration reinforces the danger of attempting to forecast growth.
“Why do Wall Streeters blithely overlook these findings as mere curiosities — simple statistics that affect others but not them? Many pros believe their own analysis is different. They themselves will hit the mark time and again with pinpoint accuracy. If they happen to miss, why, it was a simple slip or else the company misled them. More thorough research would have prevented the error… Earnings appeared to follow a random walk of their own, with past and future rates showing virtually no correlation. Recent trends (so important to security analysis in projecting earnings) provided no indication of future course… It is impossible, in a dynamic economy with constantly changing political, economic, industrial and competitive conditions, to use the past to estimate the future.”
Contrarian Investment Strategies: The Next Generation was published in 1998 -- a time of excessive froth in the market and transition within the economy. However, there is still undoubtedly a large amount of change and disruption affecting the markets today, so the book’s advice is very much applicable.
Use David Dreman’s Strategy For Dependable Investing
David Dreman’s strategy would be to steer away from using any forecasting in a company’s valuation. Whichever technique you want to use to evaluate a company, Dreman provides a critical rule to remember:
“A review of the literature on overconfidence turns up three major reasons for a wide-ranging optimistic bias. First, people have unrealistic optimism about future events. Second, they have unrealistically positive self-evaluations. Third, they have unrealistic confidence in their ability to control a situation… People also overestimate the skills and the resources at their disposal to ensure a favorable outcome, while they underestimate the likelihood of problems affecting them personally… A good rule to train yourself to follow: Be realistic about the downside of an investment, recognizing our human tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.”
David Dreman’s strategy reminds us to stay honest about the potential negative aspects of an investment. As humans, we prefer to focus on the positives or upside of an investment opportunity. At the same time, we ignore the downside risks, even if they are unmistakably obvious. The expert’s over-optimistic and confident projections clearly show a sense of ignorance to the downside potential of an investment.
As investors, it is very difficult to avoid falling victim to psychological bias. Using David Dreman’s strategy outlined in his book Contrarian Investment Strategies: The Next Generation, we identified the presence of expert, over-optimism, and overconfidence bias. The first step to fighting back is making yourself aware. Reading Contrarian Investment Strategies: The Next Generation is a great place to start.
Remember, exceptional market-beating returns are very possible if you do basic things correctly. Follow David Dreman’s strategy by assessing the validity of experts, ignoring the buy, sell, or hold indicators, and stop attempting to forecast the future!
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