Use a Contrarian Strategy to Pick Stocks

Physician's Money Digest, January 2006, Volume 13, Issue 1

Contrarian Investment Strategies:

The Next Generation

Acommon personality traitamong the strategists I followis that they are contrarians,or at least claim to be. By goingagainst conventional wisdom, theyhave an edge over most other marketwatchers who, presumably, followthe herd. David Dreman has made acareer of calling himself a contrarian,using this word in the title of hisbook, (Simon& Schuster; 1998).

Contrarian Investment

Strategies: The Next Generation

Dreman, a student of the psychologyof markets and investors, goesafter battered stocks and out-of-favorcompanies—what other investors view as dregs.These stocks are already beaten down, which makesany additional significant price drops unlikely(though not impossible). I've summarized Dreman'sstrategy as outlined in . Although a simplifiedversion, it should give you a solid understandingof the criteria he uses to find contrarianlikeinvestment opportunities.

Medium to large cap stocks: Thelargest 1500 companies are good picksbecause they are in the public eye.

Earnings trend: Look for a risingtrend in the reported earnings for themost recent quarters.

Earnings-per-share growth: Theprojected rate for the first 6 monthsshould be greater than the projectedgrowth of the S&P 500 during thesame period of time.

Ratios in the bottom 20%:Price-to-earnings, price-to-cash flow,price-to-book, debt-to-equity, andprice-to-dividend ratios should be inthe bottom 20% of the overall market.

Current ratio: This measure of a company'sability to pay its current debts in 1 year or less isdesirable for investors.

Low payout ratio: If the company's recent payoutratio is less than its 5-to 10-year historical average,then there is a lot of room for the company toincrease its dividend.

Return on equity (ROE): A high ROE helps toensure that there are no structural flaws in the company;it should be greater than the ROE earned fromthe top 33% of the 1500 large cap stocks. Anythingover 27% is staggering.

Pretax profit margins: Should be at least 8%,and anything over 22% is considered great.

Yield: A high yield of at least 1% that can bemaintained or increased.

If used correctly, Dreman's methodology can helpinvestors find financially sound companies whosestocks are underappreciated and unloved. What'smore, this strategy helps remove emotion from theinvesting equation. As Dreman says, investor psychologyis why most people cannot use contrarian strategies,even though they provide superior results.

John P. Reese is chief executive officer of Validea Capital

Management (Validea.com), a money management firm that utilizes

strict principles to manage money for high-net-worth individuals.

His book, The Market Gurus: Stock Investing Strategies

You Can Use from Wall Street's Best (Dearborn; 2002), has sold

over 30,000 copies. A columnist for RealMoney and MSN Money, Mr. Reese is a

graduate of Harvard Business School and holds two US patents in the area of

automated stock analysis.