Famous contrarian investor and the Chairman of Dreman Value Advisors, David Dreman in his best seller, Contrarian Investment Strategies: The next Generation, giving 41 rules for an intelligent investor to remember when dealing with equity investment selection.
A sure thing almost nobody plays
Rule #1: Do not use market timing or technical analysis. These techniques can only cost you money.
Experts err predictably and often
Rule #2: Respect the difficulty of working with a mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits.
Rule #3: Don’t make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.
Rule #4: Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.
The failure rate among financial professionals, at times, approaching 90%, indicates not only that errors are made, but that under uncertain conditions, there must be systematic and predictable forces working against the unwary investor.
A 1 in 50 billion shot
Rule #5: There are no highly predictable industries in which you can count on analysts forecasts. Relying on these estimates will lead to trouble.
Rule #6: Analysts forecasts are usually optimistic. Make the appropriate downward adjustments to your earnings estimate.
Rule # 7: Most current security analysis required a precision in analysts estimates that is impossible to provide. Avoid methods that demand this level of accuracy.
Rule #8: It is impossible, in a dynamic economy with consistently changing political, economic, industrial and competitive conditions, to use the past to estimate the future.
Overconfidence
Rule #9: 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 original projections.
Paying through the nose for growth
Rule #10: Take advantage of the high rate of analysts forecast error by simply investing in out-of-favor stocks
Rule # 11: Positive and negative surprises affect the “best” and “worst” stocks in a diametrically opposite manner.
Rule #12:
- Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.
- Positive surprises result in major appreciation for out-of-favor stocks, while having minimum impact of favorites.
- Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.
- The impact of earning surprises continues for an extended period of time.
Rule #13: Favored stocks underperform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.
Rule #14: Buy solid companies currently out of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.
Contrarian strategies
Rule #15: Don’t speculate on high prices concept stocks to make above average returns. The blue-chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman or women.
Rule # 16: Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price-to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.
Contrarian stock selection
Rule # 17: Buy only contrarian stocks because of their superior performance characteristics.
Rule # 18: Invest equally in 20 to 30 stocks, diversified among 15 or more industries (if your assets are of sufficient size)
Rule #19: Buy medium or large sized stocks listed on the NY Stock Exchange or only the larger companies on NASDAQ or the American Stock Exchange
Contrarian strategies within industries
Rule # 20: Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.
Rule # 21: Sell the stock when its PER (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.
Rule # 22: Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in a markedly different outcome.
Rule # 23: Don’t be influenced by the short term record of a money manger, broker, analyst or advisor, no matter how impressive; don’t accept easy cursory economic or investment news without significant substantiation.
Rule # 24: Don’t rely on the “case rate”. Take into account the “base rate” – the prior probabilities of profit or loss.
Crisis Investing
Rule # 29: Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell.
Rule # 30: In a crisis, carefully analyse the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny.
Rule # 31:
- Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clinker.
- Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.
Rule # 25: Don’t be seduced by recent rate of return for individual stocks or the market when they deviate sharply from past norms (the “case rate”). Long term returns of stocks (the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.
Rule # 26: Don’t expect the strategy you adopt will prove a quick success in the market, give it a reasonable time to work out.
Rule # 27: Push forward an average rate of return is a fundamental principle of competitive markets.
Rule # 28: It is far safer to project a continuation of the psychological reactions of investors that it is to project the visibility of the companies themselves.
What is Risk
Rule # 32: Volatility is not a risk. Avoid investment based on volatility.
Small Stocks
Rule # 33: Small-cap investing: Buy companies that are strong financially (normally no more than 60% debt in the capital structure for a manufacturing firm)
Rule # 34: Small-cap investing: Buy companies with increasing and well protected dividends that also provide above-market yield.
Rule # 35: Small-cap investing: Pick companies with above average earning-growth rates.
Rule # 36: Small-cap investing: Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one.
Rule # 37: Small-cap investing: Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.
Rule # 38: Small company trading (e.g. NASDAQ): Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.
Rule # 39: When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large your total cost will be.
Rule # 40: Avoid the small fast=track mutual funds. The track often ends at the bottom of a cliff.
Rule # 41: A given in markets is that perceptions change rapidly.