Profiting from Investors’ Overreactions
IN THE PRECEDING CHAPTER we surveyed the four important contrarian strategies that will let us not only survive but be successful in today’s markets, and we’ve seen the spectacular results they provide over time if used properly. In this chapter we’ll introduce a new investment hypothesis that seems to explain markets and investors’ behavior, as well as risk, far better than does EMH. Now, how can we put its findings to work?
Disproving an old hypothesis and bringing out a new one in its place is always difficult for the proponents of the new one. Though advocates won’t be burned at the stake or be under house arrest for the rest of their days, you can be sure that their work will be scrutinized by legions of graduate students all attempting to find even the slightest flaw, down to the punctuation marks. The old theory is the security blanket for the reputations and work of distinguished academics who have devoted their lives to researching, expanding, and broadening the ideas of the accepted hypothesis, the large number who have been taught its efficacy, and the many thousands who work with it almost daily in the investment field because they believe in its validity, as well as the millions of people who depend on its findings to improve their portfolios’ results.
Whether the new challenger in the field works or not has almost no significance to the believers in the prevailing theory—at least for the first fifty years or so. But for the reader there’s a very different possibility. You don’t have to stand on a soapbox and declare that you’re a contrarian. All that’s required is to reinvest your capital according to the contrarian strategies laid out and withdraw the gains when the time is right.
From the previous chapters, you know that our new hypothesis is built on a considerable amount of evidence in hand and a substantial amount of investigation already carried out. But it remains what it is declared to be, a hypothesis.
That is why research continues and why we cannot “close the books” on investing strategies or portfolio approaches. Even though the results have been so encouraging along the way, more work lies ahead to open up new paths and strategies and to more closely link the contrarian findings to the powerful psychology that is responsible for them.
We’ve come a long way on the major causes of investment misfires in today’s markets. Very few investors will be successful in the contemporary environment without an understanding of how to handle these pitfalls. Now, with this knowledge of what we face, we are ready to move on to the rewards, which, if we stay within the guidelines of our new psychological knowledge, are there for the taking.
Sadly for many, this is the investment world we must deal with today. But as we know, it is often in times of turmoil that new ideas are looked at through new eyes and are accepted. Far from doom and gloom, I believe, we’ll see major opportunities ahead. But to reach them, it is important to know what we are fighting and the tactics that will give us the highest probabilities of success.
Section I: The Investor Overreaction HypothesisWe have seen throughout this book that investors overreact to events and then correct their original reactions by causing major reversals in stock prices. In chapters 1 and 2, we repeatedly saw the enormous swings from frenzied overoptimism in bubbles and manias to the inevitable panic, when prices were often brutally knocked down by as much as 80 to 90 percent. Affect, sometimes accompanied by other cognitive heuristics, stands out as the most likely psychological force causing this investor behavior. But it is not only in manias, contagion, and panics that these predictable overreactions take place.
We see them consistently in far more normal market settings. Take the behavior of earnings surprises described in chapter 9. The “best” stocks, those with the most promising prospects by various yardsticks from high P/E to high price to book value to high price to cash flow, always underperform significantly as a group when they have earnings surprises. Similarly, the “worst” stocks, in terms of the same benchmarks, almost always outperform. The amount of both under- and overperformance is large, about 7 percent a year, which is 70 percent of the average 9.9 percent annual return on stocks since the mid-1920s.
An important cause of the consistent underperformance of the “best” stocks comes from investors’ and analysts’ overoptimism about their ability to pinpoint earnings, even though the empirical evidence shows emphatically that it can’t be done. This overoptimism and the focus on predictable growth, both manifestations of Affect, are the most important components of security analysis in our times and are growing more important each year. Forget Graham and Dodd, who concentrated on a wide range of fundamentals and financial ratios and would completely reject the narrow focus of analysts today. Most of us either directly or indirectly still follow these newer analytical guidelines, unsuccessful as they have proved to be in recent decades.
In the preceding chapter we saw how out-of-favor stocks have sharply outperformed the favorites for many decades. Statistics by Kenneth French, often Eugene Fama’s coauthor, on his Web site indicate that this outperformance has taken place in every decade since the 1940s.*60 As Figures 10-3 and 10-4 showed, an investor who purchased $10,000 in low-P/E stocks in 1970 would have thirteen times the money of someone who purchased $10,000 of the high-P/E index at the same time. Yet a study by Mark Peterson, then of Deutsche Bank, indicates that only about 3 percent of stocks held by equity mutual fund investors are contrarian holdings.1
Again, the answer is Affect. We inherently like the “best” stocks or industries and stay well away from the “worst.” It doesn’t matter if we’ve made the same error dozens of times; the influence of Affect is too strong not to influence our decision-making processes. Affect is very easy to detect in the case of a bubble or a mania—after the fact, of course. But it can also act very subtly when most people select “best” over “worst” stocks or when they ignore the evidence that earnings surprises favor “worst,” not “best,” stocks. If we look at mental disorders, we find that it’s easier for a psychiatrist to diagnose severe paranoia or schizophrenia than to identify neurosis, in which people’s behavior often seems normal. The situation is similar with Affect; it’s far easier to look at the effects of manias and bubbles than to see the influence of Affect in more normal markets, where price fluctuations are far more moderate. But the data indicate that Affect has a robust effect in these cases, too.
The evidence of consistent and predictable overreactions to events through this book, some new, some discovered over recent decades, led me to the investor overreaction hypothesis, which I introduced in the original edition of Contrarian Investment Strategy in 1979. Although the term “overreaction” is almost as old as markets themselves, I developed a testable hypothesis. At that time there were only a handful of anomalies to test, notably the superior performance of out-of-favor stocks and the consistently better performance of lower-rated bonds. Both anomalies had shown superior results for many decades. Sanjoy Basu,2 in 1977, and behavioral finance pioneers Werner De Bondt and Richard Thaler refer to investor overreaction in their 1985 paper,3 but limit it primarily to the performance of “best” and “worst” stocks. A stronger version of this hypothesis, reinforced by new psychological discoveries in both Affect and neuroeconomics, is presented here. The number of anomalies in which overreaction takes place has jumped manyfold in the intervening decades.
THE INVESTOR OVERREACTION HYPOTHESIS DEFINED
The investor overreaction hypothesis (IOH) states that investors overreact to certain events in a consistent and predictable manner.
This is based on the psychological forces we examined in detail in the research findings in Part I and the new biologically demonstrated discoveries of neuroeconomics, as discussed in chapter 9.
Three central predictions of IOH are:
1. Investors will consistently overvalue favored stocks and undervalue out-of-favor stocks.
2. Investors will find themselves overoptimistic on the forecasts of “best” stocks and too pessimistic on those of “worst” stocks over time. As a result, earnings surprises tend to favor “worst” stocks as a group in a predictable and consistent manner.
3. Over time both favored and out-of-favor stocks will regress to the mean because of earnings surprises and other fundamental factors, which will result in the underperformance of the “best” stocks while those considered “worst” will outperform.
These predictions are borne out in the market history that we have examined in detail earlier. Unfortunately, we won’t run out of good illustrations anytime soon. Let’s look at a few more that are in line with IOH-predicted investor behavior.
Investors extrapolate positive or negative outlooks well into the future, pushing the prices of favored stocks to excessive premiums and those of out-of-favor stocks to deep discounts. (The performance of “best” and “worst” stocks can be directly compared, of course, but “best” and “worst” investments can also be instruments other than stocks, and “best” might be in a different market from “worst.”)4 In 1980 and again in 2009 through August 2011, for example, “best” investments included gold—which peaked at $850 an ounce in 1980 before regaining this high again in 2008 and moving up to $1,892 in August 2011—and “worst” included tax-exempt municipal bonds, yielding as high as 15 percent as bond prices plummeted. Premiums or discounts on favored or out-of-favor investments can be substantial and last for long periods of time.
Similar reactions have been noted since the early 1900s with lower-rated bonds, which provide higher returns after adjustments for default levels over time. Such consistent above- or below-average returns are also likely to exist in other financial markets.
The investor overreaction hypothesis states that it is far safer to project a continuation of investor overreaction based on what we know psychologically, backed by the robust findings we have reviewed, than to attempt to project the visibility of the stocks or other investments themselves.
TWELVE KEY PREDICTIONS OF THE INVESTOR OVERREACTION HYPOTHESIS (IOH)
Here’s a full list of the predictions based on the IOH:
1a. Absolute contrarian strategies provide superior returns over time.
1b. Out-of-favor stocks, as valued by at least three different major fundamental measurements—low price-to-earnings, low price-to-cash-flow, and low price-to-book-value ratios—will outperform the market as a group over longer periods of time, normally five to ten years or more.
1c. Favored stocks, as measured by high price-to-earnings, high price-to-cash-flow, and high price-to-book-value ratios, will underperform the market over the same time periods.
1d. Out-of-favor stocks should significantly outperform favorites over the same time periods.
2a. Relative contrarian strategies provide superior returns over time. (For details of this strategy, please refer to chapter 12, “Contrarian Strategies Within Industries,” page 310.)
2b. The out-of-favor stocks in each industry will outperform the market over longer periods of time, normally from four to six years.
2c. The favored stocks in each industry will underperform the market over the same time periods.
2d. The out-of-favor stocks in each industry should outperform the favorites in each industry over the same time periods.
3. Favored stocks as a group are overvalued and out-of-favor stocks undervalued. Over time both groups will regress to the mean because of earnings surprises and other fundamental factors, which will result in the underperformance of the “best” stocks, while those considered “worst” will outperform, as both move toward a more average valuation.
4a. IOH posits that the outperformance of out-of-favor stocks and the underperformance of favorites is caused primarily by behavioral influences (Affect, cognitive heuristics, neuroeconomics, and other psychological variables).
4b. The role of Affect applies on an industry-relative basis for most and least favored stocks, as it does to stocks on an absolute basis.
5. There are two distinct categories of earnings surprises:
a. Event triggers—significant positive surprises on the lowest-valued group of stocks and major negative surprises on the highest-valued group. Both result in a consequential impact on the categories’ price movement.
b. Reinforcing events—negative surprises in the lowest-valued group and positive surprises in the highest-valued group. Both have small relative impacts on stock movements.
6a. Surprise will normally have a much smaller impact on the 60 percent of stocks in the three middle quintiles, which are less over- or undervalued using the fundamental value criteria previously noted.
6b. Even without the occurrence of an event trigger, the “best” and “worst” investments regress toward the market average over time, with the “best” stocks underperforming the “worst” ones, whether high price-to-book-value, high price-to-earnings, or high price-to-cash-flow ratio is considered, as chapter 9 demonstrated.
7. A significant part of current investment theory is dependent on accurate forecasting. The IOH predicts that:
a. Analysts’ and economists’ consensus forecasts are overoptimistic over time.
b. Analysts’ consensus forecasts on individual stocks will show substantial errors over time, resulting in significant mispricing of stocks on an almost continual basis.
c. Analysts’ consensus forecasts on industries will also show substantial errors over time, resulting in significant mispricing of stocks on an almost continual basis.
8. Investor overoptimism occurs regularly in a number of important market activities, including:
a. IPOs.
b. Analysts’ and economists’ overoptimistic earnings estimates.
9. The overreaction occurs prior to the event trigger or other factors that lead to a reevaluation of the “best” and “worst” stocks. After the event trigger other reevaluation forces occur that continue the reversion to the mean. “Worst” stocks continue their rise in price and “best” stocks their fall for a period of years.
10. The overreaction-versus-underreaction debate in current financial theory is actually about the two parts of the same process, as findings demonstrate.5*61
11. Because mispricing of securities is constant, markets are continually readjusting securities values. Stock and other financial markets are thus never in equilibrium, contrary to the teachings of EMH and most economic theory.
12. The efficient-market risk hypothesis is questionable,6 and there is no robust evidence that greater volatility results in higher returns or lower volatility results in lower returns.
To recap, our five contrarian strategies, which are all in accordance with the assumptions of the investor overreaction hypothesis, are:
1. Low-price-to-earnings strategy
2. Low-price-to-cash-flow strategy
3. Low-price-to-book-value strategy
4. High-yield strategy
5. Low-price-to-industry strategy
THE PSYCHOLOGICAL CHOICE: EMH OR IOH?
The efficient-market risk theory and a good part of economic theory are built on the unproved assumption of almost omniscient investor rationality dating from the eighteenth century. As we know, the assumption disregards recent major psychological findings as well as other behavioral work over at least the last century. The efficient-market hypothesis has not worked and cannot work for this reason. By contrast, the robust psychological finding that investors frequently overreact supports the investor overreaction hypothesis.
Because the investor overreaction hypothesis is based on psychological principles, it is also likely to apply in other fields where risk and uncertainty exist. The current empirical evidence of the findings supporting the IOH is significant. It is expected that with time the list of such evidence should grow considerably. A part of the evidence used to build the IOH was considered to be a series of aberrations by efficient-market believers and dismissed as anomalies.
CRITICAL IMPLICATIONS OF IOH
1. The fact that “best” and “worst” stocks continue to exist in all markets indicates that constant rational pricing, though a cherished EMH concept, has never existed. The investor overreaction hypothesis rejects EMH teaching and conclusions as they are currently presented almost en masse.
2. In many instances IOH is diametrically opposite in its assumptions and conclusions to EMH, and IOH reaches very different conclusions from EMH given the same facts. As we’ll soon see, a very different and hopefully improved method for measuring risk will be put forth. In the 1987 crash, for example, the investor overreaction hypothesis would have cautioned against the interaction of index arbitrage and portfolio insurance that led to a lethal market overreaction and the devastating panic that followed. One of IOH’s goals is to decrease the causes of major market overreactions and their sometimes devastating consequences. High levels of leverage and liquidity have a long-standing record of creating serious downturns, often accompanied by panic. IOH would thus caution against high leverage and massive illiquidity, because of the dangers of a major overreaction. EMH risk theory ignores them entirely, because, under its assumptions, the only risk is volatility, although, as we saw in chapter 5, this situation resulted in three major panics and crashes.
3. Unlike EMH and general economic theory, the IOH does not accept the belief that equilibrium in markets has ever existed or will exist. In a dynamic, continually changing global economy, thousands of new political, economic, investment, and company-related inputs come up almost instantaneously and are immediately integrated into the marketplace. Decision making, as a result, is always changing, and this makes equilibrium as elusive as finding the Fountain of Youth.
4. The IOH attempts to see the world as it is, not in the idealistic manner that all too many economists have adopted using the rationality assumption. By comparison, the IOH has built its assumptions on recent well-proved findings of human behavior, and its conclusions are supported by strong statistical findings that investors do behave in the manner that the IOH predicts. It may fall short of a ten commandments for contrarians, but remember, all twelve predictions of the IOH have been confirmed to a high level of statistical probability in the studies reviewed in chapters 9 and 10.
Section II. Four Contrarian Strategies Derived from the IOHNext we are going to discuss how to use contrarian strategies to boost portfolio results using the findings we have just garnered from the investor overreaction hypothesis. It’s important to understand that with ideas, just as with a college course, it’s not the amount of information we cram into our brains that does any good but how we apply critical thinking to the subject matter.
MORE RECENT CONTRARIAN PERFORMANCE
You are certainly entitled to ask if these contrarian strategies or any others still work in this new, sometimes alien, investment world, where many of the rules seem to have been washed away. The answer is a definite yes, as Figures 11-1 and 11-2 demonstrate. They cover a very short but explosive period of time, including the bursting of the dot-com bubble in the 2000–2002 period, followed almost immediately by the housing bubble, the ensuing financial crisis, and the market rebound in 2009.
This time was anything but a cakewalk, but out-of-favor stocks appear to have weathered the storms much better than favored stocks. The chart shows that $10,000 invested in any of the four contrarian strategies from 2000 through 2010 would have outperformed the market through this period. Low-P/E stocks provided the highest return, 11.7 percent annually versus 5.6 percent for the market in what is becoming known as the “lost decade.” The three other metrics, low price-to-cash flow, low price-to-book value, and high yield, also outperformed the average, again the Compustat 1500. All four metrics of favored stocks again underperformed the market and all but the low yield had negative returns. The best was low yield, at 2.4 percent annually. The worst were high price-to-cash flow (–2.9 percent annually) and high price-to-book value (–3.0 percent annually). The differences in performance between “best” and “worst” stocks were large. Both low P/E and low price-to-book value returned 11.7 percent more than their higher growth counterparts.
How, then, can you build a portfolio that should outdistance the market while providing better protection when the bear growls? And, since a good sell discipline is one of the hardest things to develop, what guidelines should you use? The guidelines I’ll add in this chapter and the next, including several new ones based on the 2007–2008 market collapse, though certainly not guaranteed to get you out at the top (if you know of any that are, please write), have a high probability of success.
But before figuring out when to sell to protect your profits, let’s figure out what to buy. Fortunately, there are four proven ways to do this.
CONTRARIAN STRATEGY 1: LOW-PRICE-TO-EARNINGS STRATEGY
The low-P/E strategy is the oldest and best documented of all the contrarian strategies and the one most used by market professionals today. Although there are many ways to calculate a P/E ratio, the most common is to take reported earnings for a company (before nonrecurring gains or losses) for the last twelve months and then divide them into the stock price. The strategy has outperformed in both up and down markets since the mid-1930s and probably will for a good deal longer.
Figure 11-3 shows the returns of the low-P/E strategy for the forty-one years ending December 31, 2010, using the 1,500 largest companies on the Compustat database.7 The return the investor receives each year is broken down into its two basic components: capital appreciation and dividends.
The stocks are sorted in the usual manner into five equal groups in each quarter of the study, strictly according to their P/E rankings, and the returns are annualized.8
Figure 11-3 once again demonstrates the superior performance of the low-P/E group. Over the forty-one years of the study, the bottom P/E group averaged a return of 15.2 percent annually, compared with 11.6 percent for the market (the last set of bars on the right) and 8.3 percent for the highest-P/E group. The lowest P/Es beat the highest P/Es by 6.9 percent a year, almost doubling the annual return over this forty-one-year study. If you’re putting money away for your retirement fund, this performance differential becomes enormous over time, as Figures 10-3 and 10-4 indicated.
Looking at Figure 11-3 again, you’ll see that these stocks also provided higher dividend yields. As the figure also reveals, the low-P/E group yielded 4.5 percent over the life of the study, compared with 3.2 percent for the market and only 1.4 percent for the highest-P/E group. The dividend return advantage of “worst” over “best” stocks was 3.1 percent annually. On a $10,000 investment over forty-one years, the difference in ending portfolio value between the 4.5 percent yield and the 1.4 percent yield portfolios would be $43,098.
But look at the appreciation column in Figure 11-3. Something is way out of whack here. The experts say that the “best” stocks, in this case those with the highest P/Es, should have the largest appreciation. But that’s not the case. They have the lowest appreciation, while the investment doggies, the low P/Es, have the highest. All the money that goes into capital expansion for the “best” stocks does not reflect itself in top-gun performance. The down-and-outers once again outstrip the top tier. Low-P/E stocks provide the best of both worlds: higher yield and better appreciation, something that conventional wisdom states shouldn’t happen.
The higher dividend returns, incidentally, help prop up the prices of cheap stocks in bear markets, one of the important reasons why low-P/E and other contrarian strategies outperform in bad times.
If you don’t like to trade much, contrarian strategies are for you. Returns stay high with little or no portfolio turnover. Table 11-1 shows how buying stocks in the lowest P/E quintile and holding them for periods of two to eight years over the 1970–2010 period would have done. As a glance at the table shows, the results are rather remarkable. The low-P/E portfolios still provided by far the highest annual returns for the five-year period (15.2 percent), sharply outdistancing the highest-P/E group (9.4 percent), and the market (12.0 percent) The low-P/E returns stayed well above the market and high-P/E returns for both the three- and the five-year periods as well as for eight years.
It’s surprising that the returns stayed as high as they did for so long. This indicates that the undervaluation of low-P/E stocks is very marked. Holding the lowest 20 percent of stocks for nine years (not shown) still provides above-market returns for the low-P/E group, with virtually no deterioration of performance from year 1. For high-P/E stocks, the overvaluation is just as significant (not shown). Even after five years, they continue to display much lower returns than the market.
Another advantage of low-P/E and other contrarian strategies is that they don’t require a lot of work to be effective. As we just saw, rebalancing low-P/E portfolios annually with large-sized companies results in far-above-market returns. However, you could rebalance far less frequently. This is a low-intensity strategy with high-intensity results. You don’t have to spend much time agonizing over the stocks you pick and monitoring or interpreting every company, industry, or economic squiggle to divine all-important information. Just select your portfolio (we’ll look at how to do this shortly) and put it on automatic pilot. You’ll save annoyance, not to mention taxes, commissions, and transaction costs, this way. At the same time, you’ll outdistance the market by a comfortable margin, and as you know, few money managers can do that. The point of the chart is not to get you to hold a portfolio intact into eternity but to show that our normal work ethic of constantly being busy to be successful is not useful but often counterproductive in investing.
Though I wouldn’t buy a portfolio and hold it without looking at it for eight years, Table 11-1 (a large sample of stocks over the last forty-one years) demonstrates that you can make big bucks in the market by positioning yourself carefully at the beginning and fine-tuning moderately thereafter.
CONTRARIAN STRATEGY 2: LOW-PRICE-TO-CASH-FLOW STRATEGY
Let’s now look more specifically at another important contrarian strategy, selecting stocks by price-to-cash flow. Cash flow is normally defined as after-tax earnings, with depreciation and other noncash charges added back. Cash flow is regarded by many analysts as more important than earnings in evaluating a company, because management can reduce apparent earnings by setting up reserves or taking write-offs or increase them by not taking adequate depreciation or other necessary charges. Although these entries do not show in earnings, they do read loud and clear in the statement of cash flow, which the Federal Accounting Standards Board (FASB) has required companies to issue since mid-1988.
All this was changed by new methods of manipulation by companies such as Enron and WorldCom. In the late 1990s, Enron, employing great skill, borrowed money from Citigroup and other banks and showed it, through complex but fraudulently recorded transactions, as cash flow. After Enron collapsed and its auditor, Arthur Andersen, facing criminal charges, voluntarily surrendered its license to practice, the banks paid billions of dollars in damages for their role in the scam. WorldCom improperly accounted for more than $3.8 billion of expenses, dramatically overstating its earnings. In short, if the scammers are good enough, even cash flow can bite you unless you can trust the company. Figure 11-4 provides the results of low price to cash flow.
CONTRARIAN STRATEGY 3: LOW-PRICE-TO-BOOK-VALUE STRATEGY
Price-to-book value was a favorite tool of Benjamin Graham and other earlier value analysts,9 and Figure 11-5 gives the results of each. The sample, the time period, and the methodology are identical to those used for price-to-earnings. Looking again at Figure 11-4, price-to-cash flow, and Figure 11-5, price-to-book value, you can see the superior performance of the “worst” stocks, the lowest 20 percent of price-to-cash flow or price-to-book value, over the top 20 percent. The similarity of results is remarkable. The low-P/E strategy is somewhat more rewarding, returning 15.2 percent annually for the forty-one years of the study versus 14.3 percent for low price-to-book value and 14.1 percent for low price-to-cash flow.
But all three value strategies handily beat the market and sharply outperform the “best” stocks in each case. Once again, we see the key ingredients of outperformance: low price-to-cash flow and low price to book value have significantly higher dividends than the market and more than triple the dividend of the “best” stocks in each category, providing a good contribution to total return. Too, look at the appreciation of the low-price-to-cash-flow and low-price-to-book-value groups. By this measurement, both groups handily outperform not only the most favored stocks but also the market. The accepted reason for buying “best” stocks, much higher appreciation, is thus shown to be fallacious.
Figures 11-3, 11-4, and 11-5 again demonstrate that contrarian stocks give you the best of both worlds: higher appreciation and higher dividends. The bottom quintile provides dividend returns three times as large as the highest-P/E quintile, another easy win for out-of-favor stocks.
Figures 11-3, 11-4, and 11-5 demonstrate that the conventional wisdom of setting radically different investment goals for conservative and aggressive investors is simply one more investment myth. Which brings us to another important investment Psychological Guideline:
PSYCHOLOGICAL GUIDELINE 23: Don’t speculate on highly priced concept stocks to make above-average returns. The blue-chip stocks that widows and orphans traditionally choose normally outperform the riskier stocks recommended for more aggressive businessmen or-women.
Stocks classified as “businessman’s risk” by many brokerage firms, because of their low dividends and high price-to-book-value ratios, often turn out to be losers. As a group, they consistently underperform the market. A better term might be “businessman’s folly.” Figures 11-3, 11-4, and 11-5 go far to disprove the concept of “businessman’s risk” for buying stocks. It still might be an “all-American” concept, but it is far less widespread today, touted primarily by brokers, who pick up more in commissions.
The strategy of buying the lowest 20 percent of stocks by either price to book value or price to cash flow, as we have seen, holds up through both bull and bear markets. Buying and holding portfolios of the lowest-price-to-cash flow and lowest-price-to-book-value stocks without any change in their composition for periods of two, three, five, and eight years (not shown) provide returns very similar to those of buying and holding the lowest-P/E portfolio (Table 11-1). Investing in these two groups results in returns well above the market’s and sharply higher than the favored stocks in each group for every period up to eight years.10 The “best” stocks continue to underperform for these extended periods.
Again we see that you don’t have to watch the market like a gunslinger, ready to slap leather at any new piece of information. Relax; you’ll probably make far more by taking your time. And there is the collateral reward of not shooting yourself in the foot by moving quickly and incorrectly, as is often the case with the pros.
The final reward, and one of the most important, of the buy-and-hold approach, as indicated with low-P/E or the other low-price-to-value strategies, is that lower transaction costs and taxes can result in a substantial increase in your capital over time. Transaction costs are often not recognized by investors but can add up, particularly on less liquid stocks. What these three low-price-to-value strategies can do for you over time, then, is provide returns high enough that only a minimum of trading is required, thereby reducing, perhaps substantially, these costs and enhancing your portfolio returns. This leads us to another helpful Psychological Guideline:
PSYCHOLOGICAL GUIDELINE 24: Avoid unnecessary trading. The costs can lower your returns over time. Buy and hold strategies provide well-above-market returns for years and are an excellent means of lowering turnover and thereby significantly reducing taxes and excess transaction costs.
The three major strategies show markedly superior returns for “worst” stocks while avoiding extra trading costs. Finally, since yield is a very important factor for many readers, let’s look at the high-yield strategy.
CONTRARIAN STRATEGY 4: HIGH-YIELD STRATEGY
Figure 11-6 provides the annual returns of high-yield strategies. The method and period used are the same as those for the previous three strategies. As the chart indicates, however, high-yielding dividend strategies perform somewhat differently from the previous contrarian strategies. The highest-yielding stocks outperform the market by 0.9 percent and the stocks with low or no yield by 4.0 percent annually.
However, the composition of the returns is different. More than half of the 12.5 percent annual return of the highest-yielding group comes from the yield itself. Moreover, appreciation, at 6.0 percent annually over the forty-one-year period, is lower than for any of the other “worst” groupings or for the market. Buying stocks with high dividend yields beats the market but provides lower total returns than the previous three contrarian strategies.
Once again a buy-and-hold strategy works well for the lowest-price-to-dividend group. Not only do you continue to beat the market over time with this method, but your returns actually increase with a longer holding period.*62 The average yield, as shown in Figure 11-6, was 6.5 percent annually through the study. Also of note is that the dividend rate increases with time and may yet surprise us again as recessionary conditions slacken.
For investors who require income, this appears to be a far better strategy over time than owning bonds. If interest rates spike up, bond prices will go down sharply. The price of a thirty-year bond, for example, will drop 12 percent for every 1 percent increase in interest rates. With the wide fluctuations of interest rates in recent decades, the bond market has actually been almost as volatile as the stock market. Buying high-yielding stocks makes good sense for the yield-conscious investor. Dividends go up over time; interest payments on bonds do not. Yes, we are in a highly abnormal period today, with short Treasuries yielding almost nothing. But, as chapter 14 will detail, this is likely to be another bad trap for investors.
High-yielding stocks also provide you with the best protection in most bear markets, as we saw in Figure 10-5a. These stocks give the dividend-oriented investor more protection of principal on the downside and often provide both rising dividend income and capital appreciation; the latter occurs only rarely with long bonds.*63 However, this strategy does not always work, as we know all too well from the horrific bear markets, such as 2007 and 2008, followed by 2009–2010, when the dividends of many high-yielding stocks were cut to the bone and people traded even relatively secure dividend income for the absolute, albeit temporary, security of Treasuries. Fortunately, a bear market of this magnitude and severity occurs only once in generations.
Is this strategy for everyone? I don’t think so. It works best for people who need a constant source of income. Naturally, unless you hold the stocks in a tax-free account, the income is taxable. And in a tax-free account an investor is far better off using one of the three other contrarian strategies—depending of course on immediate income requirements—which, as we saw in Figures 11-3, 11-4, and 11-5, provide significantly higher returns over time than the high-yield strategy.
Value, then, in the form of contrarian strategies, is the closest thing there is to a strategy for all seasons in the stock market. Now for some application guidelines that will help you implement various contrarian strategies.
Section III. Contrarian Strategies in Action1. CONTRARIAN STOCK SELECTION: THE A-B-C RULES
The initial problem confronting all investors is how to select individual stocks and the number of stocks to hold in their portfolio. A few simple guidelines have proved their worth over the years:
A. Buy only contrarian stocks because of their superior performance characteristics.
B. Invest equally in thirty to forty stocks, diversified among fifteen or more industries (if your assets are of sufficient size).
Diversification is essential. The returns of individual issues vary widely, so it is dangerous to rely on only a few companies or industries. By spreading the risk, you have a much better chance of performing in line with the out-of-favor quintiles shown above, rather than substantially above or below that level.11
C. Buy medium- or large-sized stocks listed on the New York Stock Exchange or only larger companies on NASDAQ or the AMEX.
Such companies, upon which the studies have been based, are usually subject to less accounting gimmickry than smaller ones, and this difference provides some added measure of protection. Accounting, as we have seen, is a devilishly tricky subject and has taken a heavy toll on investors, sophisticates as well as novices.
Larger- and medium-sized companies provide investors another advantage: they are more in the public eye. A turnaround in the fortunes of Ford (which occurred in 2009) is far more noticeable than a change in the fortunes of some publicly owned steak restaurant franchise buried, say, in the sand and wind of Death Valley. Finally, larger companies have more “staying power”; their failure rate is substantially lower than that of smaller and start-up companies.12
2. SHOULD WE ABANDON SECURITY ANALYSIS ENTIRELY?
As we have seen, selecting stocks by their contrarian characteristics and placing no reliance on security analysis has given better-than-average returns over long periods of time. Should we, then, consider abandoning security analysis entirely? The evidence we’ve seen certainly shows that it doesn’t help much. However, I would not go quite this far (and not just because I’ve been thoroughly steeped in the doctrines of the Old Church). I believe parts of it can be valuable within a contrarian framework.
Contrarian methods eliminate or downgrade those aspects of traditional analysis, such as forecasting, that have been shown to be consistently error-prone. By recognizing the limitations of security analysis, you can, I believe, apply it to achieve even better results within the contrarian approach. However, for a lot of you, a well-diversified contrarian index fund built on the principles in this book would be a solid way to invest. Unfortunately, there are very few out there to choose from. Our firm manages a series of contrarian index funds from large cap to midcap to small cap.*64 Why there are so few baffles me. Over thirty years, contrarian performance has sharply outperformed the market and the various index funds out there, from small to mid to large. It’s an idea whose time has come, but it does require a pretty careful reading of the funds’ prospectuses as well as a thorough watch over their portfolios to make sure the fellers are actually managing the money the way they say they are.
In the next sections, I’ll attempt to show you how five fundamental indicators can be used to supplement the A-B-C Rules of contrarian selection we just looked at. Following this analysis, we’ll examine other contrarian methods that do not depend on security evaluation. These, too, should provide above-average market results. After reviewing the various methods, you can choose which suits you best.
3. FIVE SELECTION INDICATORS
In my own application of the low-P/E approach, I select from the bottom 20 percent of stocks according to P/E. The lowest quintiles provide plenty of scope for applying the ancillary indicators that follow.
If, after what you’ve seen, you are brave enough to dabble in security analysis, here are the indicators I consider most helpful:
Indicator 1. A strong financial position. This card is essential in today’s market, where liquidity is hard to find. This is easily determinable for a company from information contained within its financial statements. (The definitions of the appropriate ratios—current assets versus current liabilities, debt as a percentage of capital structure, interest coverage, and so on—can all be found in any textbook on finance, as well as in material provided free of charge by some of the major brokerage houses.)*65
A strong financial position will enable a company to sail unimpaired through periods of operating difficulties, which contrarian companies sometimes experience. Financial strength is also important in deciding whether a company’s dividends can be maintained or increased. And of course in a liquidity crisis, such as the one that we have just gone through and that continues to linger, it is often the difference between survival and insolvency. Mercifully, serious crises of this sort occur only every century or so, or did. In any case, companies with financial strength not only survive but often prosper in such times. Look no farther than Warren Buffett’s Berkshire Hathaway.
Indicator 2. As many favorable operating and financial ratios as possible. This helps ensure that there are no structural flaws in the company. Again, the definitions of such ratios can be found in standard financial textbooks.
Indicator 3. A higher rate of earnings growth than the S&P 500 in the immediate past and the likelihood that it will not plummet in the near future. Such estimates are an attempt not to pinpoint earnings but only to indicate their general direction. Remember that we are dealing with stocks in the bottom quintile, for which only the worst is expected. Unlike those who use conventional forecasting methods, we do not require precise earnings estimates; we need merely note their direction and only for short periods, usually about a year or so.
In my initial contrarian work, I was more of a purist on this subject. I thought: since contrarian strategies worked at least in part because of analysts’ errors, why bother with forecasting at all? Some rather harsh experiences have caused me to modify this position.
If, for example, the Street estimates that a company’s earnings are likely to be down for some time, I would not rush in to buy, no matter how positive my indicators appear to be. Often, as we’ve seen, analysts are overoptimistic. All too frequently, an estimated moderate decline in earnings turns into a drop off a cliff. This was the case with many of the financial stocks, from Citigroup to Wachovia to AIG, in 2007–2008, when the analysts were making estimates of relatively small declines in earnings, but those companies’ income had actually fallen off the cliff.
The important distinction between forecasting the general direction of earnings and trying to derive precise earnings estimates is that the former method is far simpler and the probability that it will succeed much higher.
Indicator 4. Earnings estimates should always lean to the conservative side. This ties in with Graham and Dodd’s margin of safety principle, even more so after our frightening trip through the lands of overoptimistic analysts. Sometimes you don’t need a pencil to recalibrate estimates to lower, more realistic levels; you need a large excavator to drop them down into their proper subterranean place. Remember, too, that by relying on general directional forecasts and keeping them ultraconservative, you are reducing the chance of error even further. If you do this and the company still looks as though its earnings will grow more quickly than the S&P for a year or so, you may have a potentially rewarding investment.
Indicator 5. An above-average dividend yield, which the company can sustain and increase. This indicator depends on Indicators 1 through 4 being favorable. We have seen that conventional thinking about dividends is far off the mark. High-yield strategies also outperform the market. In practice, I have found that Indicator 5 improves performance when used in conjunction with the primary rules of buying contrarian stocks.
Now that we have looked at five indicators that should prove helpful regardless of the contrarian strategy we use, I’ll turn briefly to another matter. A question I’m frequently asked is “What is the best approach to contrarian investing? Is it better to select one method, such as price to earnings or price to book value, and focus solely on it?” For me, the answer is no. Though you can certainly select one strategy and run with it successfully, once again I favor a more eclectic approach. Our money management firm uses the low-P/E method as its core strategy but also utilizes the other three contrarian strategies extensively. Investment opportunities vary, and often you can find exceptional value with one method that does not show up as clearly with another.
Low P/E is probably the most accessible of the four contrarian strategies, because the information on P/E ratios is available daily in the financial section of any large newspaper, next to a stock’s price. The information is also updated quarterly, as are price-to-cash flow and price-to-book value. Though price-to-dividend information is also nearly instantaneous, it is a secondary strategy because of the superior returns of the first three contrarian methods. However, it, too, has its moments in the sun, as we shall see.
4. CONTRARIAN STRATEGIES IN ACTION
To the Front
It’s time to move into the trenches to see how contrarian decisions are made under fire. I’ll draw on past recommendations I’ve made in my Forbes column and to the clients of our investment counseling firm, as well as examples from the Dreman High Opportunity Mutual Fund, which I manage. Though one can be accused of telling “war stories,” remembering only the victories while conveniently forgetting the setbacks (not to mention the routs), I think that it helps to present practical examples of how the A-B-C Rules and five indicators often had clear-cut results—not only with 20/20 hindsight but at the time. Our first stop will be a couple of examples of how we’ve selected low-P/E stocks.
Using the Low-Price-to-Earnings Strategy
I recommended Altria Group ($49), the parent of Kraft Foods as well as Philip Morris, in Forbes in late September 2004. Here was a classic value stock and one that was heartily disliked by a good part of the public because of its ownership of Philip Morris, the nation’s largest cigarette manufacturer, which at the time was undergoing several large class action suits. After carefully researching the class actions, we came to the decision that the cases, although generating major headlines about potentially devastating losses, were unlikely to cause serious damage to Altria with its rock-solid financial position and enormous cash flow.*66
This was the kind of stock that Benjamin Graham might have dreamed of. First, its P/E and price-to-cash-flow ratio were extremely low in 2003, at the time 10х and 9х, respectively. Moreover, it yielded 6 percent back then and had raised its dividend almost every year since the 1930s. Indicators 1, 2, and 5 were almost off the charts. But there was more.
Although Altria was under heavy legal and media assault, all the lawsuits were against the U.S. tobacco subsidiary (Philip Morris USA). When we added up the combined operations of Altria, their value, by what we considered conservative accounting, came to roughly $105 a share, with Philip Morris’s domestic value about $45, or 43 percent of our estimate of the value of the total operation. So great were the unfounded fears of the enormous size of the legal settlements that the company was trading at a larger than 60 percent discount to its real worth. Moreover, the U.S. Supreme Court was growing concerned about the size of the punitive damage awards to plaintiffs above actual damages claimed, sometimes reaching ten or even a hundred times the damage claims themselves. The Court’s concern was the size of damage awards across the board.
Our analysis was extremely thorough, particularly examining the potential for bankruptcy, which appeared very far-fetched. The Supreme Court dramatically lowered the amount that could be paid above actual damages and also tightened the rules significantly on class actions, another major benefit to Philip Morris. By March 2008, the share price more than doubled in value, including dividends.
With the demand for oil outstripping new supply since 1982 and the last million-barrel-a-day field found in Kazakhstan in 1979, oil prices had moved up fairly steadily over time until late 2008. One of the most promising industries, if oil prices rose, was the large exploration and development companies that have large oil and reserves, a good portion of them domestically. Similarly, they would perform worse than the large integrated companies, such as Exxon Mobil, Royal Dutch/Shell, or BP, if prices came down. I recommended the purchase of Apache in Forbes on July 25, 2005, at $65, when it was at a P/E of 11х, significantly below that of the market.
At the time Apache was cash rich and held major reserves. The company was rapidly increasing its spending on finding new oil and gas. Its programs in discovering major new oil in recent years, in relatively safer areas of the globe, had proved very successful.
The company spent its exploration money wisely, and its reserves grew handsomely. By the end of 2007, its price was up 70 percent from the time of the Forbes recommendation, in a market that was starting to turn down sharply. Apache was also strong, as measured by the first three indicators, and met all its objectives in a so-so market.
In 2008, the worst market collapse since 1929–1932, Apache was hit hard; with the price of oil plummeting, the stock fell to a low of $51 in early 2009 but rebounded sharply beginning in the spring of 2009. Oil prices spiked up again to $110 a barrel in the winter of 2011, and Apache shot back to $130. It has also taken advantage of a major opportunity. During the BP oil spill in the summer of 2010, it was able to buy major additional reserves from BP valued at $7 billion in fields in Canada and Egypt, as well as the Permian Basin, at what were considered to be bargain prices.
Apache was a good example of buying strong value and holding on to it through a disastrous market, because the basic reasons for doing so had not changed—that is, unless you believed another Great Depression was on our doorstep. (See Figure 11-7.)
Using the Low-Price-to-Cash-Flow Strategy
Low price to cash flow, as Figure 11-3 demonstrated, has also provided well-above-average returns over time. Price to cash flow is often a more useful measure than earnings when a company has large noncash expenses, such as depreciation in bad years.*67 If you try to buy normally low-P/E cyclical stocks in a recession, when the earnings of such companies tumble, the P/Es can get very high. This happened to BHP Billiton, one of the world’s largest natural resource producers, which I recommended in Forbes in February 2009, at $48. Although the company had relatively strong finances, its earnings began to collapse as the worldwide recession almost brought the purchase of most natural resources to a screeching halt in the last months of 2008. BHP’s earnings dropped 62 percent, from their record high of $5.11 in fiscal 2008 (ended June 30) to $2.11 in fiscal 2009, and the company’s cash flow also dropped about 50 percent, but with its strong cash flow in prior years and its financial strength this was more than adequate to cover the company’s requirements.
Once again stories were spun out in the financial pages, and sometimes on front pages, of how major industrial firms and mines might take years to recover. Apparently forgotten was that BHP was one of the lowest-cost producers of natural resources globally. With the mild recovery, earnings and cash flow bounced back strongly in 2010, in line with where they had been in its second best year, 2007. By December 2010, BHP, trading at $93, had almost doubled from the price at which I had recommended it in Forbes. So strong was its cash flow that it raised its dividend rate 50 percent in 2008 and another 17 percent in 2009. That BHP increased its dividend at all, rather than markedly, indicated management’s confidence that the company was rock solid because of its financial strength, despite the sometimes frightened comments by both analysts and the press. (See Figure 11-8.)
And a Strikeout!
Fannie Mae, a blue chip for generations, appeared to be a cheap stock trading at $37 near the end of 2007, when it was recommended. The company had had above-average earnings growth for decades. True, the mortgage market for subprime and other riskier mortgages was dropping rapidly, the company had been running at a loss for several quarters, and there were slick roads ahead, but Fannie had been through numerous bad housing markets since it was founded by the Roosevelt administration in 1938. The company and its somewhat smaller counterpart, Freddie Mac, had much tighter credit standards than the banks, the S&Ls, and the investment banks. An examination of their default ratios confirmed that over time their credit standards had been much higher for buyers to qualify for mortgages, and their default ratios had been much lower. The stock was purchased because it had a strong mandate, a protected business model, and historically good earnings growth, as well as a low P/E ratio.
What was not known at the time or in subsequent interviews with senior management, including the chairman of the board, was that the pastoral landscape the executives painted verbally was far removed from the facts. Under severe pressure from both the Democrats, led by Congressman Barney Frank, and the Bush administration, led by James B. Lockhart III, the head of the Federal Housing Finance Agency (FHFA), which regulated Fannie and Freddie, enormous political pressure was put on Fannie and Freddie. They were repeatedly threatened with the loss of their vital low-cost financing if they didn’t make increasingly larger amounts of mortgages available to lower-income groups.
In the spring of 2008, both Treasury Secretary Hank Paulson and New York Fed president Tim Geithner indicated that both companies had excess capital above their regulatory capital requirements. Geithner announced that because Fannie and Freddie’s operations were improving, he was reducing their capital requirements so that they could loan even more to the rapidly falling mortgage market. He made similar announcements through August 2008, with, it appeared, at least the tacit approval of Treasury Secretary Paulson.
Then, on September 6, 2008, both companies were put into receivership by the U.S. Treasury; they now trade for only pennies. In a subsequent announcement it became clear that both Fannie and Freddie had buckled under the intense pressure they were facing and had put substantially more money into “NINJA” (no income, no job or assets) mortgages, often with virtually no down payment. Naturally, all the senior Fed, administration, and congressional officials walked away, blaming Fannie for its poor lending practices. The carnage continued, and the S&P 500 Financial Select Sector SPDR (the market weight of all financial stocks in the S&P 500) dropped 83 percent from 2007 to early March 2009, the largest decline since the 1929–1932 crash and in a shorter period.
What went wrong with our analysis and those of most value managers of Freddie and Fannie, the banks, and the investment banks? Here are a couple of important lessons which I have extracted from this painful experience:
1. Never buy a company that is losing money. Losses are an early-warning system that all is not well. Most good companies do turn around, but when they don’t you get stung. The contrarian studies that we looked at always excluded companies that had an earnings loss in any quarter, and the results over time were just fine.
2. This one is hardly worth writing about but inevitably takes a major toll. Never, never believe senior officials up to the cabinet level when they say all is well in trying times for a company or an industry. In most cases that’s the time to let the stock or industry go. (See Figure 11-9.)
Using the Low-Price-to-Book Value Strategy
Price to book value, even more than price to cash flow, is an excellent contrarian indicator when a company stumbles and earnings crater. A good example was the bank stocks in the financial crisis of 2007–2008. As the subprime crisis intensified, financials, as we saw, plummeted. JPMorgan Chase, under Jamie Dimon, its savvy CEO, was one of the first of the major banks to recognize the gravity of the subprime situation, and in 2007–2008 it began to both lessen its activities in those markets and reduce its sizable portfolio of those and other lower-rated mortgage holdings. Its price to book value was substantially lower than the market’s, as were those of most financial stocks.
But there was one major difference: JPMorgan Chase’s book value was by and large real. Because of its greater liquidity as a result of its pulling back on the purchase of illiquid mortgages, the Federal Reserve and the Treasury struck an advantageous deal with it that allowed it to buy Bear Stearns, one of the largest Wall Street investment banks, on Sunday, March 16, 2008. The price was $2 a share,*68 a 93 percent discount from where Bear had closed the previous Friday. Although there were other bidders, JPMorgan Chase was the only credible contender and got a sweetheart deal from the Fed, paying only $1.5 billion for the firm, whose assets included its headquarters building, worth an estimated $1.2 billion. The Fed also agreed to fund up to $30 billion of Bear Stearns’ troubled assets as well as provide it with special financing for the transaction.13 The purchase gave JP Morgan Chase a major foothold in the investment banking business, where it had lagged behind other major competitors.
If lightning is not supposed to strike twice in one spot, there is no such idiom about “white magic.” In late September 2008, the FDIC, after a bank run on Washington Mutual (WaMu), sold the nation’s largest thrift to JPMorgan Chase for approximately $1.9 billion. Included in the sale were $307 billion in assets, $188 billion in deposits, and 2,200 branches in fifteen states.14 To put the size of the WaMu sale into context, the company’s assets were equal to about two-thirds of the combined book values of all the 747 thrifts that had been sold off by the Resolution Trust Corporation, the government body that had handled the savings and loan crisis from 1989 through 1995.15 The deal vaulted JPMorgan Chase into first place nationwide in deposits.
The company’s strong price-to-book-value ratio and the high quality of its financial assets allowed it to build a financial empire. True, it was tough sledding for a while. In March 2009, it traded at just over 40 percent of book value, at $16. But by April 2010, it was once more above $45.
The enormous advantages of expanding profitability: it added the largest branch banking systems in the country; and a fully integrated investment banking department, given to it by the regulators for pennies on the dollar, was achievable only because of its financial strength. These acquisitions will be likely to lead to major payoffs over time. (See Figure 11-10.)
Using the High-Yield Strategy
The high-yield strategy, as we have seen, also provides above-average returns. At its most effective, it can be used with other contrarian methods to ferret out undervalued stocks, providing a combination of above-average income and reasonable appreciation. As noted, a high yield, even if earnings are temporarily depressed, indicates management’s confidence in the future. How management and the board of directors react to a serious problem is usually worth noting.
At times the utility stocks are an example of a group where a combination of high yield and low P/E allows investors to score well. High yield also works well in tandem with low price to book value.
This brings us to Southern Company, a utility company that operates four utilities with 4.4 million customers in Georgia, Alabama, Florida, and Mississippi. The company has shown slow but reasonably consistent growth for years. Every once in a while, as with most utilities, its stock price dips because of minor concerns that dissipate shortly thereafter. One such case came in mid-2002, when Southern’s stock fell to $24, where it traded at a P/E of 13х and yielded 5.6 percent. The stock’s earnings and dividends continued to grow over the next 51/2 years, together returning 109 percent through 2007, when it yielded 7 percent on its original purchase price. Investor overreaction, as this example shows, is not confined solely to high-volatility stocks; utility and consumer nondurable buyers also get their chance on occasion. (See Figure 11-11.)
Contrarian Strategy Performance Summary
All five of the successful examples—Altria Group, BHP Billiton, Apache Corporation, JPMorgan Chase, and Southern Company—demonstrate a beneficial side effect of these strategies. Often contrarian stocks can move substantially higher in price and still be good holdings. The reason: earnings are moving up rapidly enough that the P/E, price-to-book-value, and price-to-cash-flow ratios remain low.
The contrarian approach I present has worked well both for my clients and for myself over time. Though I would be the last to argue that the record is definitive, the strategy has succeeded through both bull and bear quarters.16 Although the degree of success will certainly vary among individuals—and for the same individual over differing time periods—this approach seems to be an extremely workable investment strategy, eliminating most complex judgments.
Indicators 1, 2, 4, and 5 are reasonably straightforward calculations, avoiding the major portion of Affect, configural, and information-processing problems previously discussed. And Indicator 3, which projects only the general direction of earnings, is much simpler and safer to use, and consequently should have a better chance of success, than the precise estimates ordinarily made by security analysts. Obviously, this is one of the methods I favor most.
As an investor, you may choose to follow this strategy as I have laid it down or look at other variations in the next chapter that should also allow you to outperform the market. But before you do this, let’s visit the contrarian casino. You should really like this one because the odds in the casino favor the players. In fact, the question is: who really owns the casino?
Section IV. What Are the Probabilities of Success Using IOH?FINDINGS
At this point I think I hear a few murmurs out there—and rightly so. There are zillions of how-to investment books touting this method or that. Are there any real odds that contrarian strategies will beat the market over time? Indeed there are.
Calculating the returns of our forty-one-year study of the 1,500 largest stocks on the Compustat database, we find that the odds of contrarian strategies’ outperforming the market are about sixty–forty in any single quarter. The casinos in Las Vegas and Atlantic City make a bundle with odds 5 to 10 percent in their favor. The probabilities of beating the averages using contrarian strategies, then, are even higher than the casinos’. Let’s look at these probabilities in detail. The results, I think, will surprise you.
First, in investing, unlike in Las Vegas, even if you do only as well as the market, you will walk away with your pockets bulging. You don’t just get your cash back; you get it compounded. Ten thousand dollars invested in the market, as Figure 10-3 showed, results in a portfolio value of $913,000 forty-one years later. In the market casino, just breaking even would give you ninety times your money in forty-one years.
However, Figure 10-3 also demonstrated how well you would have done in contrarian strategies over time. Using the low-price-to-cash-flow strategy, you would have more than doubled the performance of the market, increasing your $10,000 of initial capital 216-fold. With price to book value, you would have outperformed price to cash flow somewhat, increasing your capital a modest 242 times. Investing in stocks produces enormous returns, even if you do only as well as the market. If you adopt a contrarian strategy, the results are spectacular.
You may have some questions at this point. First, is forty years a realistic time frame? How many people invest for anything near this time? If you are in your twenties or thirties, twenty-five or thirty years is not unreasonable, particularly if you are building your nest egg in an IRA or another retirement plan.
But as Table 11-2 demonstrates, you also get mouthwatering gains for shorter periods. The table indicates the amount that $10,000 would become in periods of five to twenty-five years relative to the market using the four contrarian strategies we have examined.17 As you can see, all four strategies whip the market in every period. And the percentage they do it by goes up dramatically with time. Low P/E had the best returns overall. In five years, using the low-price-to-earnings strategy, you outdistance the market by 18 percent. This rises to 69 percent in fifteen years and 101 percent in twenty. And look at the difference compounding makes. At the end of five years, again with the price-to-earnings measure, the return is $3,203 over the market’s; by ten years it increases to $12,419; and by the end of twenty-five years to $209,687. Remember, this is an initial onetime investment of only $10,000.
“There’s no question that contrarian strategies look impressive, if not overwhelming, in studies,” some readers would say, “but what are my chances of beating the market in practice?” Then there are other problems to deal with, such as the 2007–2008 crash, which cut out a large chunk of most people’s retirement and savings plans.
Again, let’s look at our chances of outdistancing the market over time in terms of the odds at a casino. Using our forty-one-year study,18 we know that the odds are sixty–forty in our favor in any single play. But what are they over a large number of hands? In market terms, that would mean playing these strategies over some years.
To determine the answer, we use a statistical calculation, not by coincidence called the Monte Carlo simulation. We treat each quarter as a single card. Since we have a forty-one-year study, we have 164 quarters. Using low P/E as our strategy, we randomly pick a quarter from the 164 quarters in the forty-one years and calculate the return against the market, whether it is positive or negative. The card is then put back into the 164-quarter deck. We then randomly select another card in the same manner, calculate the return, and again put it back into the deck. This allows any quarter to be drawn more than once and other quarters to be missed entirely.
In effect, we are taking any possible combination of market returns over the 164 quarters of the study to determine just what the probabilities of beating the market are. A game would consist of 100 draws for each hand, which would total twenty-five years.19 This gives us an almost unimaginably large number of combinations, which provides very accurate odds of how well a strategy will work over time. The Monte Carlo simulation allows us to get billions of possible combinations (actually 164100, or more than the number of inches from here to the Andromeda galaxy, which is two million light-years away).
But most investors don’t make a onetime investment in the market; they put away a few thousand dollars or more each year. Not wanting to bore the computer, we asked it to calculate the odds of beating the market for 10,000 plays of each strategy, investing sums from $1,000 to $20,000 dollars annually. The computer did this for the four value strategies, with only a minor whine at the monotony.
Table 11-3 shows the result of investing these amounts using the low-P/E strategy against the market over time. As you can see, the dollars you accumulate using a contrarian strategy are almost mind-boggling. An investment of only $1,000 a year over twenty-five years in a tax-free account would become $262,709. An investment of $20,000 a year would, by the same method, become $5,254,173.
If you used the low-P/E strategy and repositioned your portfolio quarterly into the lowest-P/E group, what would be your odds of beating the market over twenty-five years? High enough to make the owner of the plushest casino drool. If you play a 100-card series 10,000 times, your probabilities of winning are 9,978 out of 10,000! That’s right, chances are you would underperform the market only twenty-two times in 10,000, or about two tenths of 1 percent on each hundred-card play.20 And remember, this casino is different; even underperforming the market sends you away not with empty pockets but with a large stack of chips if you get even a reasonable percentage of the market’s return.
But say that twenty-five years is much too long for you to invest—what would happen if you move to a ten-year span? Using this strategy for ten years would reduce your chances of beating the market, but not by much. You would still come out a winner 9,637 times out of every 10,000 hands you played, not bad in casinos or markets. If you invested for five years in this manner, your odds of beating the market would still be 90 out of every 100 hands. The probabilities of winning with this strategy are a gambler’s or an investor’s fantasy.
But let’s stop for a moment. Maybe you don’t like to turn a part of your portfolio each and every quarter. Such a strategy might be too anxiety-producing; it might drive you, along with the rest of the players, to Prozac. How do we do if we opt for a longer holding period, say a year, without changing any part of the portfolio? Once again, this casino pays off like a dream. If you play this strategy for one-year periods for the full length of the study, making modest changes to the portfolio annually, your odds go up. But I’m sure you’ll take them—try winning 9,998 of 10,000 hands. If you want to go for shorter periods, your odds of beating the market decrease somewhat but are still high—99 percent for ten years and 94 percent for five years.
The probabilities are nearly identical for price to cash flow and price to book value. A casino owner would die for these odds rather than the roughly fifty-five–forty-five the house gets. In fact some casino owners, including “Bugsy” Siegel, pushed daisies for far lesser odds.
These odds are by far the highest consistently available of any investment strategy I am aware of. There is nothing closer to a sure thing for millions of investors, yet, strangely enough, few play this game.
The contrarian wing has always been sparsely populated, and, despite all the statistics, it’s likely to remain so.
Walking Away from the ChipsIt’s important to realize that investing using contrarian strategies is a long-term game. One roll of the dice or a single hand at blackjack is meaningless to a casino owner. He knows there will be hot streaks that will cost him a night’s, a week’s, or sometimes even a month’s revenues. He may grumble when he loses, but he doesn’t shut down the casino. He knows he’ll get the money back.
As an investor, you should follow the same principle. You won’t win every hand. You’ll have periods of spectacular returns and others you might diplomatically describe as lousy. But it’s important to remember that contrarian strategies, like a casino’s odds, put you in the catbird seat. Professional investors, along with everyday folks, often forget this important principle and demand superior returns from every hand.
Even though a strategy works most of the time and generates excellent returns, no strategy works consistently. The fast-track, aggressive growth stocks will, on occasion, knock the stuffing out of low-P/E or other contrarian methods for several years at a clip—sometimes for much longer, as they did between 1996 and early 2000. But over time, it’s simply no contest. Low P/E came back strongly in 2000 and 2001, sharply outperforming growth for the preceding ten years. Still, human nature being what it is, our expectations are almost always too high.
Is it possible for everyone to handle contrarian strategies? I’m confident that the underlying psychology we’ve looked into in some detail will remain valid, and I think most of us would take the bet that human behavior is remarkably invariant. But attitudes do change, and strong market movements, particularly by groups of exciting stocks, invariably bring about changes in the way people think. It is very hard for many, no matter how much they know, to take the odd cold shower while everyone else seems to be having a great time in the Jacuzzi.
It’s almost impossible to underestimate the power of Affect, neuropsychology, and other psychological influences on our decisions. As a trained professional investor well versed in the new psychology, I’m certainly not immune, nor is anyone else. Enthusiasm, despondency, and fear tug at me just as hard as at most people, but knowledge gives you a better hand far more often than not. Still, it’s no whitewash.
Even when we look at the record of these superb returns, which encompass both bull and bear markets over decades, we are still disappointed that a contrarian strategy doesn’t win each and every year. The probability is very low that any investment strategy will, just as it is that you’ll win a hundred straight hands at blackjack. That’s obvious—if we were totally rational data processors. But we are not. We demand the impossible and repeatedly make poor decisions in pursuit of the unattainable.
Take the following example of how easily a winning strategy can be abandoned. In 1998 and 1999, growth investing sharply outperformed the value approach. Many value managers trailed the S&P 500 by 14 or 15 percent when the market was up 56 percent in the 1998–1999 period. These strategies continued to underperform for several years. The chant went up from some consultants and sophisticated clients that value was dead. “Contrarian strategies might have worked well in the past,” many said, “but now, with almost everyone using them, they aren’t effective anymore.”
Then contrarian strategies did the unthinkable—they underperformed by even more in the first two months of 2000. How could this happen? Fidelity Investments replaced its leading contrarian manager, George Vanderheiden, in early 2000 with a growth team. Vanderheiden had managed the $7.2 billion Fidelity Destiny I fund as well as two other funds for almost twenty years.
The over $4 billion contrarian fund I was managing saw its assets drop by almost 50 percent as shareholders fled to hot Internet and fast-growing dot-com funds. The underperformance by contrarian stocks was worse than I had ever experienced. I wondered how many years it would take for me to catch up with the high-flying NASDAQ market, where the large majority of those hot stocks traded.
The answer was not years but months. By mid-March, the Internet bubble began to disintegrate and dot-com and high-tech stocks plummeted. Concurrently, Dreman Value Management’s contrarian portfolios and mutual funds skyrocketed. By the end of 2000, our portfolios were up 40 percent, while the S&P 500 dropped 9 percent. We had made up not only all the underperformance we had lost between 1997 and 2000 in a little under ten months but a good deal more. As for George Vanderheiden, a Wall Street Journal article written several years later calculated that had his original portfolio been left intact, the fund he had managed so successfully over time would have been 40 percent above where it was under the new managers.
Again, it was simply the laws of probability. Contrarian stocks have an excellent record of doing better in bear markets, but that doesn’t mean they will do so every time (they don’t have to in order to get the well-above-average returns we saw in bear markets in Figure 10-5a). Still, when they don’t do better, consultants and professionals, as well as individual investors, believe the strategies have lost their edge. Large numbers of investors, from giant institutions to individuals, abandoned them at that point, which happened to be right at the bottom of their performance cycle. From then on, those strategies outpaced the market handily for years.
Experience Is a Good TeacherMy own experience, as well as that of many other contrarian money managers, is similar. Over the past thirty-five years, I’ve seen this same syndrome occur virtually every time contrarian stocks underperformed the market for any length of time. If you can live with the few bad periods and the odd terrible period, you should do very well. However, following through is much more difficult than it may appear. One last but very important Psychological Guideline:
PSYCHOLOGICAL GUIDELINE 25: The investor psychology we’ve examined is both your biggest ally and your worst enemy. In order to win you have to stay with the game, but for many people that is difficult to impossible.
Though the strategies are simple and easy to use, the influence of immediate events is very powerful. We looked at why most people can’t shake off these influences and at some of the principles that can help you to do so in Part I. Next let’s look at the new, sometimes alien, world we face as investors and the strategies we can use to get through it.
