Contrarian Buys: A Dreman Portfolio

03/09/2016 9:00 am EST

Focus: STOCKS

John Reese

Founder and CEO, Validea.com And Validea Capital Management

John Reese, editor of Validea, analyzes the strategies of the market’s most legendary investors; in turn, he then develops model portfolios based on these time-test strategies. Here, he looks at contrarian investing legend, David Dreman.

Dreman noted that there was only a 1 in 130 chance that analysts' consensus forecasts would be within 5 percent for any four consecutive quarters. Ouch!

But according to Dreman, the fact that analysts are so often wrong is good news for disciplined contrarian investors. To understand why, you need to understand to beliefs that are at the core of his strategy.

First, he found that investors -- being emotional human beings -- are prone to overreaction.

Second, Dreman found that surprises occur frequently in the stock market, and that many of those surprises involve earnings results that differ significantly from analysts' estimates.

When you put investors' tendency to overreact together with the frequent surprises in the market, you get to the crux of why Dreman believed so much in a contrarian approach:

Because the best stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them.

On the other hand, because they already tend to be undervalued, the worst stocks don't have much further down to go when bad surprises occur. When good surprises occur, however, they have a lot of room to grow.

His conclusion was to buy out-of-favor stocks because earnings surprises are commonplace. If you own favorites, you'll get clobbered by negative surprises but won't get much upside by positive surprises.

However, if you own out-of-favor stocks, you'll hardly be penalized for negative surprises but will be rewarded handsomely by positive ones.

For our Dreman-based model portfolio, we look for unloved stocks — those that are in the market's cheapest 20 percent using at least two of the following ratios: p/e, price/book, price/sales, price/cash flow.

At the same time, this model also looks for stocks with strong underlying fundamentals (high returns on equity, strong recent earnings growth, high and sustainable dividend payouts).

Below are the current stocks that make up our Dreman-based contrarian model portfolio:

Navient (NAVI)
Korea Electric (KEP)
GlaxoSmithKline (GSK)
Valero Energy (VLO)
AES (AES)
HSBC Holdings (HSBC)
Huaneng Power International (HNP)
Tesoro (TSO)
TIM Participaceoes (TSU)
MGIC (MTG)

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