Diamonds in the Rough

08/06/2014 12:00 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

In his Validea newsletter, John Reese follows the strategies of numerous market legends; here, he discusses the famed-contrarian advisor David Dreman and highlights a trio of stocks that meets his Dreman-based criteria.

Steven Halpern:  Our guest today is John Reese, editor of the industry-leading newsletter, Validea.  How are you doing, today?

John Reese:  Great, thank you, Steven.

Steven Halpern:  You followed the strategies of a wide variety of what would be considered the market's most legendary investors and, despite their differing approaches to the stock market, you note that they share a common leaning.  Could you expand on that?

John Reese:  Sure.  When it comes to most of the gurus like Warren Buffett, Benjamin Graham, or Joel Greenblatt, they tend to zig when the rest of Wall Street zags or zag when Wall Street zigs, so they are contrarian. 

They go against what most of the rest of the market is saying.  They've got the strength of the conviction to march to their own drumbeat and not follow the crowd and they go after what tends to be very unpopular and, therefore, undervalued stocks. 

Steven Halpern:  So, today we're going to focus on one guru who is arguably the most contrarian of all, David Dreman.  Could you first share some background for listeners who might not be familiar with Dreman's history?

John Reese:  Sure.  Dreman is considered The Dean of the Contrarians.  His Kemper-Dreman High Return Fund was one of the best performing mutual funds ever.  It ranked the top one out of 255 funds in his peer group over a ten-year period starting 1988, according to Lipper Analytical. 

When he published his book, Contrarian Investment Strategies: The Next Generation-and that's the book upon which I base my Dreman strategy-his fund was ranked Number One in more time periods than any of more than 3,000 funds in Lipper's database.

Throughout his career, he keyed in on the down and out diamonds in the rough, finding winners in such beaten stocks as Altria, after the tobacco stock plummeted amid lawsuit concerns and Tyco, which had been hit hard by an embarrassing CEO fiasco.

Steven Halpern:  Now you note that investor psychology plays a significant role in his strategy.  Could you expand on that?

John Reese:  A huge role. At the core of his research is the belief, investors tend to overvalue for the "best stocks," those hot stocks everyone seems to be buying and they grossly undervalue the worse stocks, those that people avoiding like the plague, so because of that, he targeted the unloved stocks that people and key analysts were avoiding.

So, my Dreman-inspired model looks for firms whose valuations are in the cheapest 20% of the market in two or more of the following categories where they've got a very low price to earnings ratio, price to cash ratio, price to book ratio, or price to dividend ratio.  Those are all ways of indicating true unpopularity or truly being unloved.

Steven Halpern:  So, an important step in this is that surprises play a role in the success of this approach.  Could you comment on that?

John Reese:  Yes, very much so, so, surprises include events, frequent events like earnings, beats or misses-includes government actions that impact industry, news about new products or news about countries, so, with regards to earnings, Dreman found that analysts were actually more often than not, wrong as to compared to right about their earnings forecast, so that leads to a lot of surprises in the market.

So, now, because the best stocks are overvalued, they're actually priced to perfection.  Good surprises really can't increase their value that much, but bad surprises, however, can have a hugely negative impact on stocks like, let's say, Google (GOOG) or Apple (AAPL). 

Well, in the meantime, the worst stocks, they're so undervalued, they're so under-popular that they don't have much further down to go when bad surprises specific to the companies occur.

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But when good surprises occur, say an earnings beats its forecast, they've got a lot of room to rise, so focus on the unloved stocks, avoid the hot stocks and, according to Dreman, you've got a good chance of making a lot of money.

Steven Halpern:  So now, Dreman also felt that just because their stock was overlooked by Wall Street didn't necessarily make it a good buy.  What factors did he look at to determine if a stock might be a worthy candidate for purchase?

John Reese:  So, that's a good point.  You can't just merely take an unloved, unpopular stock with those low ratios and assume that that's going to do well, so he found that there were several factors when he selected the stocks that made a big difference. 

He was looking for high returns on equity.  Generally, he wanted to see that the companies were not just profitable, but had a higher pretax profit margin than average.  If a company had a high dividend yield that was a plus, not a requirement.

But then the payout ratio for the company had to be lower than the historical average so that they could have room to increase their dividends and he wanted to see higher earnings and S&P growth over the past six months, so he wanted to see if the company had reached an actual bottom and it turned around.

Another financial measure of solidness that he really looked at was the current ratio, so he wanted the current ratios to be the higher than its industry average are greater than 2.0, which indicates pretty strong cash financial position for a company.

Steven Halpern:  As you alluded to earlier in our conversation, you maintain portfolios based on these various gurus-including a model portfolio based on the Dreman strategy.  How has that portfolio done over the years?

John Reese:  That portfolio has done well.  The 10-stock portfolio returned 105%, which is 6.7% annualized since its mid-2003 inception, at which, beats the S&P 500, and that doesn't even include annualized dividends, which tends to add 3% or 4% per year on top of that, however, I also want to say that it's one of the more volatile strategies; has a beta of 1.21, so it's been a great performer.

Steven Halpern: Okay, so maybe you would be kind enough to highlight some of the specific stocks that are currently held in the Dreman-based portfolio.

John Reese:  Certainly.  One of them is Canada's largest communication company with a $35 billion market cap called BCE (BCE).  It offers broadband communications to both residential and business customers and also has assets in TV, radio, digital media, and it has cut price to cash flow. 

Price to dividends are in the lowest 20%.  It has got an 83% EPS growth rate over the past six months; 5% dividend and its payout ratio is well below historical average, and it's debt to equity ratio is much below the industry average, so that's one. 

Another one is Mobile TeleSystems (MBT).  This is interesting, because this is a Russian telecommunication firm, but they have got 100 million mobile subscribers in Russia, Ukraine, Uzbekistan, Armenia, Belarus.

Of course, the huge Russian/Ukraine fears right now have driven this to be truly cheap.  People have really tried to get out of Russia, which is creating this great opportunity, yet this company still has a 53% return on equity, 24% pretax profit margins, and its dividend yield is 7.8%. 

A third one that the Dreman model likes right now is a Brazilian utility with the nickname CEMIG, long name: Compania Energetica de Minas Gerais (CIG). 

Its price to earnings, price to cash flow are in the bottom 20% of the market, yet it has 27% return on equity and 30% pretax profit margins and its debt to equity is basically less than one-half of what the industry debt to equity is.  By the way, I am long all three of those companies.

Steven Halpern:  Well, we really appreciate you taking the time today.  It's always fascinating to speak with you.

John Reese:  Thank you very much, Steven.

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