Saturday, August 23, 2008

The New Contrarian Investment Strategy: Chp3: The Slippery Rock

The fundamental analyst takes into account all available information that could affect a company’s stock price, synthesizes the information and determines the intrinsic value of the company. In 1930, John Burr Williams defined intrinsic value to represent what a shareholder could expect to get from a stock over time. The fundamentalist believes that market forces can move stock prices away from its intrinsic value but that eventually stocks will return to their inherent values.

The main body of work that supports fundamentalist theory is the “Security Analysis” text written by Graham and Dodd in 1934 (summarized here). This text is considered the defining work for fundamental theory and it underpins the fundamental analysis occurring on Wall Street. Dreman brings up the important question of why the vast majority of professional investment institutions continue to fail to beat the market even when using fundamental analysis.

There are a few reasons given by Dreman as to why fundamental analysis may not be providing superior returns than the market. First, one branch of fundamental analysis called growth school has dominated all fundamental analysis for some time. Some of the problems with valuing growth stocks include difficulty in accurately predicting future growth trends, failure to properly identify true durable growth stocks and the changing market sentiment of the appropriate price to earnings multiple to use in pricing a growth stock.

Many practitioners of Graham and Dodd's methods fail to achieve good investment results because of a systematic failure to apply all of Graham’s methods. Graham claims that his approach has been downgraded in favor of placing more emphasis on near term sales and earnings predictions for a company instead of looking at price to earnings ratios, book value, dividends and the financial strength of a company. Dreman conjectures this might be why Graham once said “he might be the most read and most forgotten man on Wall Street”.

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