Contrarian Investment Rules – Part 2

This is a continuation of the 41 Contrarian Investment Rules as defined in David Dreman’s Contrarian Investment Strategies.

Contrarian Investment Rules 21-41

Rule 21: Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.

• Prefer to sell when it nears intrinsic value.

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 (3 or five year) record of a money manager, bro­ker, analyst or advisor, no matter how impressive; don’t accept cursory economic or investment news without significant substantiation.

Rule 24: Don’t rely solely on the “case rate.” Take into account the “base rate“­ – the prior probabilities of profit or loss.

Rule 25: Don’t be seduced by recent rates 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.

• Guilty again to some degree.

Rule 27: The push toward 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 than it is to project the visibility of the companies themselves.

Rule 29: Political and financial crises lead investors to sell stocks. This is pre­cisely the wrong reaction. Buy during a panic, don’t sell.

• The Obama health care reform scared investors into selling UNH. Rebounded strongly once UNH revealed plans on how it can still profit.

Rule 30: In a crisis, carefully analyze the reasons put forward to support lower: stock prices-more often than not they will disintegrate under scrutiny

Rule 31: (A) Diversify extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clinker. (B) 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 32: Volatility is not risk. Avoid investment advice based on volatility.

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 an above-market yield.

Rule 35: Small-cap investing: Pick companies with above-average earnings 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.

• 40-60 small caps in a portfolio? Why not the Russel 2000 instead?

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.

• Many brokers usually charge more for sub $1 stocks. Commissions get out of control.

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.