Sunday, June 6, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 3

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Despite the wide following of technical analysis (described in Chapter 2), fundamental analysis is far more popular. Fundamental analysis is considered more sophisticated, as it relies on the study of accounting, investment, business and economic issues relevant to the security in question.

But despite the fact that fundamental analysis appears based on a solid foundation, these managers still underperform the market as a group! Dreman points to a number of problems in the way most fundamental investing is done. Instead of relying on past earnings as a guide, many analysts extrapolate growth trends into the future, which Ben Graham warned can be dangerous.

Growth investors point to the returns that would have been generated by investing in particular stocks when they became available, such as Wal-Mart in the 70s and Microsoft in the 80s. But for every successful growth stock, there are several dozen that don't pan out. For example, in the 1920s, everyone knew that the automobile industry would grow for years to come. But finding the three or four survivors from the hundreds of companies attempting to compete in the space was a near-impossible task. In the same way, with thousands of companies in the internet space, determining the winners from the losers before the rest of the crowd bids up the price is also fraught with error.

Dreman also notes that fundamental analysts increasingly rely on near-term outlooks, thus abandoning one of Graham's key principles. Graham noted that stocks should be looked at as if they were interests in private businesses; when considering the worth of private businesses, book value and replacement value are considered important measures. But when a stock goes public, all of a sudden the emphasis shifts towards current and extrapolated earnings.

After producing convincing evidence that technical analysis doesn't work, academics in the 1970s now came after fundamental analysis. Based on their measures of risk, academics purported to show that fundamental analysis does not yield positive returns. Dreman will discuss the problems with these assertions later on in the book.

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