Saturday, June 19, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 6

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.

Having shown that surprises in EPS estimates are large in both frequency and magnitude on the stock market, Dreman now focuses on demonstrating the effect surprises have on stocks of differing levels of value.

In a study covering US stocks from 1973 to 1996, Dreman found that stocks with EPS surprises in the lowest P/E, P/B and P/CF quintiles vastly outperformed those with EPS surprises in the highest respective quintiles.

But earnings surprises can come in two flavours: positive and negative. Therefore, Dreman subsequently studied the effects of both of these types of surprises on the most popular (high price-to-X) and the most out-of-favour (low price-to-X) stocks. The results showed that negative earnings had a huge effect on the high-flying stocks (these stocks lost 4.3% of their value in the quarter following the disappointment, and 8.9% of their value in the year that followed), but little effect on the out-of-favour stocks (these stocks lost only .7% of their value in the quarter following the disappointment, and remarkably only .1% of their value in the year that followed, meaning they actually increased in value in the nine months after the first quarter following the poor results).

On positive earnings surprises, however, the out-of-favour stocks reacted very well, showing 3.6% gains in the first quarter following the good news, and 8.1% gains in the year following the good news. The high-flyers (those in the highest P/E quintile, for example) showed only small gains (1.7% in the quarter following, and 1.2% in the year following).

Dreman argues that the data clearly shows that stocks trading at premiums to earnings or book value have high expectations built into them. When earnings are positive, these stocks gain little, as strong news was already priced in. When they are negative, however, they take big haircuts. Meanwhile, stocks trading at low multiples of earnings or book values have the worst already priced into the stock. As such, disappointing data does not affect the price much, but positive data can generate strong returns! This research suggests the type of companies investors should be buying...

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