Contrarian Investment Rules – Part 1

Contrarian Investment Rules – First Part

Contrarian Investment Rules

I am currently reading Contrarian Investment Strategies by David Dreman and enjoying the rules that pop out throughout the book. There are 41 in total for the contrarian. There are many obvious rules. My comments are in bullet points and the highlighted rules are the ones I found interesting.

The list of 41 rules is quite long so I’ll break it into 2 parts. Part 2 will be posted tomorrow.

Contrarian Investment Rules 1-20

Rule 1: Do not use market-timing or technical analysis. These techniques can only cost you money.

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.

• Having too much information and thinking that one has mastered the details causes the investor to become overconfident.

Rule 3: Do not 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.

Rule 5: There are no highly predictable industries in which you can count on an­alysts’ forecasts. Relying on these estimates will lead to trouble.

• Analysts cannot predict the future any better than you and me.

Rule 6: Analysts’ forecasts are usually optimistic. Make the appropriate down­ward adjustment to your earnings estimate.

• Always at the upper range in my experience

Rule 7: Most current security analysis requires 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 constantly changing polit­ical, economic, industrial, and competitive conditions, to use the past accurately to estimate the future. The past gives some frame of reference but cannot be exact.

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 initial projection.

Rule 10: Take advantage of the high rate of analyst forecast error by simply in­vesting in out-of-favor stocks.

Rule 11: Positive and negative surprises affect “best” and “worst” stocks in a di­ametrically opposite manner.

• Interesting point. He is saying that beaten down stocks don’t go down as much because nobody expects much, but if it does better, everyone is surprised and up it goes. Vice versa for darlings.

Rule 12: (A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.
(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.
(C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.
(D) The effect of an earnings surprise continues for an extended pe­riod of time.

Rule 13: Favored stocks under-perform the market, while out-of-favor companies outperform the market, but the reappraisal often happens slowly, even glacially.

Rule 14: Buy solid companies currently cut 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.

• Not a fan of buying companies based on low ratios

Rule 15: Don’t speculate on highly priced 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 woman.

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.

• Very guilty on this one. My expenses are too high.

Rule 17: Buy only contrarian stocks because of their superior performance char­acteristics.

• Disagree

Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more indus­tries (if your assets are of sufficient size).

• I’ve written about diversification here. Dreman is more of a mechanical investor so he doesn’t have to keep up with 20-30 companies. The point about industries is relevant.

Rule 19: Buy medium-or large-sized stocks listed on the New York Stock Ex­change, or only larger companies on Nasdaq or the American Stock Ex­change. (Obviously American centric here)

• Disagree. This isn’t contrarian.
  

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.

That is the first part of the Contrarian Investment Rules. Be sure to visit tomorrow for the remaining half.