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Avoid The Psychological Traps Of The Market With The Dreman Screen

This week, we cover AAII’s strategy that focuses on the Dreman screen, which attempts to avoid the behavioral traps of the market by following the principles of contrarian investing. David Dreman has long studied the psychological underpinnings of the overall stock market and its impact upon valuation levels. Unlike the rational market assumed by traditional academic studies, Dreman sees stocks and markets as driven by emotions that often push prices from their intrinsic value.

The Philosophy

Contrarian investing is a disciplined investment approach using value measures that help to avoid the emotional traps of the market. The contrarian strategy seeks to profit from other investors’ misjudgments by seeking stocks that are out of favor with the market and avoiding the high-flying fashionable stocks that have been swept up in market euphoria. Eventually the market rediscovers out-of-favor stocks and lets the high-fliers fall back to earth.

Paying a Reasonable Price

David Dreman believes that for an investment approach to be of value, it must take into account both the behavioral and interpretational obstacles of investing. Behavioral obstacles include a tendency toward crowd psychology, while interpretational obstacles include the difficulty of estimating future company value. While the price of a stock will ultimately move toward its actual intrinsic value, mistakes in estimating that value (interpretational obstacles) and market emotions and preferences (behavioral obstacles) may lead to periods of undervaluation or overvaluation.

Dreman and Benjamin Graham agree that investors pay too much for companies that appear to have the best prospects at the moment and react too negatively to companies considered to have the weakest prospects. This mistake tends to be a self-correcting process that contrarian investors can use to their advantage. The situation often reverses itself within a year. Investors seem to consistently pay too much for “visibility,” which Dreman defines as the present foreseeable future stream of earnings.

Stocks with high price-earnings ratios are vulnerable if “tastes” change. The financial press often writes about sector rotation—the process of switching from one industrial segment of the market to another better positioned for the current market environment. This investor psychological shift is often quick and dramatic.

Dreman warns not to let the valuation process become too complex. Valuation models such as the dividend discount model are theoretically sound but provide a dangerously false level of precision. Simple valuation techniques such as price-earnings ratios and dividend yields are easy to work with and have been proven effective in numerous studies.

In his own work, Dreman prefers to start the analysis among the bottom 40% of stocks according to their price-earnings ratios. This typically provides a broad enough universe from which to perform the complete analysis. We use AAII’s Stock Investor Pro program to perform the screen. Stock Investor Pro includes percentile ranks, so we are able to simply specify a criterion that looks for price-earnings ratio percentile ranks of 40% or lower. Our Dreman screening model has an annual price gain since inception (1998) of 9.0%, versus 6.7% for the S&P 500 index over the same period. Dreman cautions that investment decisions are not clear-cut, so it is best to provide for a margin of safety by starting the investment search with low price-earnings stocks.

Dividend Yield

Dreman seeks companies with a high dividend yield that the company can sustain and possibly raise. The yield helps to provide protection against a significant price drop and contributes to the total return of the investment. There are many ways to screen for dividend yield: You can simply establish a minimum level or perform a relative screen that compares the current yield to the that of the market or to the company’s historical norm. Yield screens typically exclude small, high-growth companies because these firms need all cash generated through operations to expand. If an absolute level of yield is specified in a screen, it cannot be too high or only companies from industries that traditionally pay a high dividend will pass. For our screen we specify a minimum yield of 1.5%—high enough to be significant, yet low enough not to exclude too many industries.

The dividend growth rate over the last three years also helps gauge the recent dividend policy of the firms.

Strength and Size Overcomes Adversity

Dreman favors large and medium-sized companies in his approach for three primary reasons: greater chance for a rebound if there is a company misstep, greater market visibility with the rebound and a reduced chance of “accounting gimmickry.”

In his observations, Dreman found that fewer large firms have gone completely out of business. Large companies have greater managerial and financial resources to weather a company or industry slowdown or problem. Many once-troubled firms have experienced substantial turnarounds coupled with significant price appreciation. Dreman feels that with our dynamic economy, these turnarounds can occur very quickly.

Stocks of rebounding large companies tend to be in the public eye and get noticed more quickly when things go better for the company. This should result in a higher valuation for a given level of earnings. An increase in earnings, coupled with an increase in the multiple that investors are willing to pay for a given level of earnings, translates to significant price increases.

Dreman feels that accounting is a “devilishly tricky subject.” Even when firms follow generally accepted accounting principles (GAAP), a great deal of discretion in the treatment of accounting items leads to various quality levels of earnings. Both novice and sophisticated investors have misinterpreted crucial elements of accounting statements, but larger firms with long records are watched more closely by a wider range of investors and regulators. Dreman reminds investors that it is important to carefully scrutinize the footnotes to financial statements and even suggests staying clear of a company if it has too many footnotes for a company of its size and industry.

Dreman does not provide any specific cutoff for determining company size, leaving it to the investor to determine their own level of risk tolerance. Dreman believes that the less experienced the investor, the larger the company in which they should invest.

To determine the cutoff for our screen we examine market-capitalization levels (share price times number of shares outstanding). To help provide a wider cross section of passing companies, we make our screen aggressive and use the top 30% of companies as ranked by market cap.

Financial Strength

Dreman feels that it is important to consider the financial strength of a company when pursuing a contrarian investment strategy. A strong financial position enables a company to work through a period of operating difficulty often experienced by out-of-favor stocks. Financial strength also helps to provide a measure of safety for the dividend payout.

Both the short-term obligations and the long-term liabilities of the company must be considered when testing for financial strength. Common measures of the longer-term obligations of the company include the debt-to-equity ratio (which compares the level of long-term debt to owner’s equity), debt as a percent of capital structure (long-term debt divided by capital, which includes long-term sources of financing such as bonds, capitalized leases and equity) and total liabilities to total assets. We use the ratio of total liabilities to assets for our screen because it considers both short-term and long-term liabilities. Alternatively, we could use both a measure of short-term financial strength, such as the current ratio (current assets divided by current liabilities), and a measure that examines the long-term obligations of the firm, such as the debt-to-equity ratio.

It’s Only Valuable If the Company Has Growth Prospects

Being a contrarian does not imply that an investor should purchase a company just because it has a low price-earnings ratio or a high dividend yield. A successful contrarian uses these valuation techniques to help identify stocks that may be mispriced. The companies are only attractive if they are expected to grow and prosper in the future.

Dreman seeks companies with a higher rate of earnings growth than the S&P 500 both in the immediate past and the immediate future. We are screening for companies with short-term growth in earnings greater than the overall database median and expected increases in earnings estimates for each of the next two years.

Dreman does not require precise levels of earnings estimates and instead is more concerned with the overall direction of the company. He points out that earnings estimates are terribly unreliable and best used as general guides for the company’s prospects. The AAII Dreman screen uses the historical five-year growth rate along with the consensus long-term earnings growth estimate from I/B/E/S to help provide a sense of the market expectations embedded in the stock price.

Interestingly, a study of earnings surprises by Dreman revealed that low price-earnings ratio stocks typically had more positive earnings surprises than high price-earnings ratio stocks, and the reaction was consequently more significant. Furthermore, when a low price-earnings ratio stock had a negative earnings surprise, its price drop was not as severe as that for high price-earnings ratio stocks.

A Diversified Portfolio

When selecting stocks and building a portfolio, Dreman recommends equal investment among 15 to 20 stocks, diversified among 10 to 12 industries. Dreman feels that diversification is essential with the low price-earnings ratio screen because the rates of return among the various stocks will vary greatly. It is too dangerous just to rely on a couple of stocks or industries. Dreman is using the contrarian strategy to increase the odds of outperforming the market for a given level of risk consistently over time. While a concentrated portfolio may prove to be a big winner during one period, there is also the chance that it will suffer a great loss during another period.

Conclusion

It is ironic that the “best” companies often seem to make the worst investments, while the “worst” companies can be the best investments. Too many investors trying to find the next hot stock overbid for the best prospects. Dreman puts forth that to succeed you should avoid high price-earnings ratio stocks and be careful about new issues with little substance that often sell only in rising markets when the speculative fever is rising.

11 Stocks Passing the Dreman Screen (Ranked by Price-Earnings Ratio)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

If you want an edge throughout this market volatility, become an AAII member.

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