Saturday, July 10, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 13

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.

Dreman compares the returns of stocks to those of bonds and T-bills over several historical periods. While stocks outperform bonds over long periods, the sheer magnitude of the relevant performance is not clear until the investor considers the effects of inflation and taxes.

Through most of the 19th and 20th centuries, inflation was benign. For example, in 1940 the dollar still had 88 cents of the purchasing power it did in 1802! But since World War II, inflation has been relatively strong; today's dollar only has 8% of the purchasing power it had in 1802!

Too much money chasing too few goods results in inflation, so why has inflation picked up over the last 70 years relative to the previous 150? Dreman argues that government deficits are a major contributor, as governments have tended to increase national debt levels to finance wars, entitlement programs, natural disasters, bail-outs and other events. Unfortunately, they don't run surpluses as much as they should when times are good. Furthermore, since WWII, wages have been made sticky on the way down. As such, prices rise easily but they do not come down when they should, from a supply/demand point of view.

Whatever the reasons, as long as inflation continues going forward, stocks should outperform bonds and T-Bills by an even larger margin. When the price level for goods changes, businesses can earn revenues at the higher price level, but bond holders get left receiving lower dollars amounts.

Conventional wisdom suggests diversification between stocks, bonds and T-bills, but based on the evidence presented in this chapter, Dreman argues that portfolios meant to last more than four or five years should be squarely invested in stocks. Dreman might be sued if he placed 90% of the assets of a pension plan (with a decades-long time horizon) in stocks, because it goes against the prevalent wisdom of the day, but due to inflation he believes this to be a position which will clearly outperform what are considered the more "conservative" allocations.

1 comment:

Mark Carter said...

My own theory is that we've had lots of inflation because "we" (UK) came off the gold standard. With nothing to pin a currency to a fixed asset, it was all too easy for governments to increase the money supply.

Consider the irony here: technological progress has been very rapid in this and the last century. Technology is inherently deflationary, because it allows a greater quantity of goods to be made at a lower price. Yet we live in an inflationary environment. It's all that "Quantative Easing" that's doing it.

I seem to recall that Graham (yes, THAT Graham) proposed an "Ever-growing granary". Instead of a gold standard, money should be pegged against a basket of commodities. So you could go to your Central Bank and demand your lump of coal, potato, gallon of oil and a couple of barley grains in exchange for your dollar/pound/whatever.

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