Avoid the Psychological Traps of the Market With the Dreman Screen

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

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.

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.

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.”

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.

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.

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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