Contrarian Investment Strategies - The Next Generation: Chapter 1

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.

There are probabilities of success and failure in the market as surely as there are in gambling. But Dreman argues that the odds in the market can be put in your favour. This book is about how to do just that.

The professional money manager is often described as someone who should manage your money. Armed with the best team of analysts money can buy, he is expected to be able to buy low and sell high. Unfortunately, in practice this is not how it turns out. Dreman offers a slew of statistics demonstrating that the vast majority of managers under-perform their benchmarks.

As it became known several decades ago that managers could not beat the market, Efficient Market Hypothesis (EMH) emerged as a convenient explanation. Using computational power that was not previously possible, academics were able to "prove" that market prices were "correct" and that market-beating returns were not possible.

Dreman argues that this theory is built on a foundation of hot air, and likens it to the generations of scientists that believed the earth was at the centre of the universe. When situations occurred that seriously questioned the integrity of the theory (for EMH, the 1987 one-day point drop; for astronomers, the observation of planet locations inconsistent with their revolution around the earth), new parameters were added and the theory was made more complex to try to explain these phenomena.

Dreman sees the main problem with EMH is its built-in assumption that market participants behave 100% rationally. Psychology, however, affects all of our investment decisions. By understanding the behavioural traits that affect our decisions, however, investors put themselves in a position to put the odds in their favour.

Contrarian Investment Strategies - The Next Generation: Introduction

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book from 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.

It is 1998. As Dreman writes the book, the markets continue to rise. The way the market rises reminds him of 1929. To gauge the mood of that era, he has gone back and read newspaper clippings depicting the general sentiment before the great stock market crash that preceeded The Great Depression. Upon reflection, Dreman notes that the market euphoria of today (1998) appears to surpass that of the late 20's. He also argues that the price of stocks relative to fundamentals is higher in 1998 than it ever has been.

When he wrote his book in 1982, investors were interested in art, collectibles, precious metals and diamonds. At that time, he felt that stocks were undervalued...but investors weren't interested. Stocks went on to post massive gains in the years that followed.

There are ways to determine if the market is overvalued, Dreman argues, and this book will teach investors how. The contrarian methods Dreman describes and explains throughout the book are both of a fundamental and behavioural nature. Having a good strategy only gets investors part of the way towards making more money in the market; investors also need to understand their innate psychological tendencies that will try to prevent them from carrying out a sound strategy.

Investors overreact to events, both to the upside and to the downside. This is what provides contrarian investors with the opportunities to succeed.

The first function to the strategy Dreman will provide in the book is one based on the preservation of capital. The second function will be to capitalize on market mistakes in order to derive strong returns. Since no strategy should be followed blindly, Dreman will also spend time discussing why the strategies work. The first part of the book, however, will discuss why the widely-accepted, conventional strategies just don't work.

New Era Value Investing: Chapter 10

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler discusses why an emotionless approach to investing is important. She describes 7 learning points she has picked up, the cognizance of which can help investors improve their returns:

1) Wall Street tends to extrapolate current trends to infinity

In the mid-1970s, when the US economy was mired in a prolonged recession, it seemed to many as if the US would never again enjoy prosperity. In the late 1990s, it was believed that recessions were a thing of the past.

2) It is rarely "different this time"

One of the biggest challenges faced by investors is being able to resist popular assumptions that stock markets will behave differently as a result of new forces.

3) Market pullbacks are great investment opportunities

Certain industries and sub-industries can become out of favour, but often unjustifiably so.

4) Go with your research, not Wall Street's

The best time to invest in a stock is when analysts are down on it.

5) Investment managers need to challenge their beliefs every day

Feeling uncomfortable about an investment is good, because it makes the investor search for more facts, keeping an open mind.

6) Use the financial media to your advantage

The "always-on" media can exacerbate declines, creating opportunities for those who remain disciplined.

7) It's all relative

While Graham and Dodd focused on absolute returns, Tengler argues that its relative valuation that matters

Info You Can't Get Anywhere Else

Investors who restrict their research of companies to text-based sources are missing out. While company conference calls can contain a lot of redundant and irrelevant data, there are often gems of useful info found on these calls that cannot be found anywhere else.

Yes, they can be quite boring. Many managers will start the call by reading out their entire press release, as if to somehow suggest that shareholders cannot read. And some managers speak at such a "leisurely" pace that they make William Shatner sound like an auctioneer. But it's not all management. For value investors, many of the analyst questions are simply not relevant. Whether an event (e.g. plant closure, new product launch etc.) will have its accounting impact in the 3rd quarter or the 4th quarter of 2016 is of no importance to us!

But on some calls, the questions that are asked or the insights management gives can result in the shareholder getting a great feel for certain aspects of the company. For example, on Quest Capital's most recent conference call, items that were not in any release were discussed, as a result of very specific questions that were asked. Quest is in the process of monetizing its loan portfolio. Listeners heard the following comments from the company Chairman:

"The cash on our balance sheet is ballooning, quite candidly. The issue is what to do with those ballooning cash reserves. We are cognizant of [having a] book value of $1.85/sh, and a stock price of $1.35/sh, and this discount is unacceptable. Our objective is to look at any and all alternatives to narrow the gap between net book value and market value."

When a caller asked if the company had any plans to buy back more shares, now that Quest's previously announced share repurchases have been completed, management replied that it was only allowed to do one Normal Course Issuer Bid per calendar year. If not for that, management claimed it would be buying back shares right now.

Management went on the say that the board is exploring what's called a Substantial Issuer Bid so that it can purchase more shares without waiting for the end of the year. Dividends were also discussed as a means for distributing cash. (Considering these options, however, I would venture a guess that dividends would not be management's favourite option right now.)

The conference call made it clear that cash is currently flowing in, and that management is exploring some very specific ways of distributing that cash that can result in a significant upward effect on the company's share price. None of this information is available in any press release!

Incidentally, cost-conscious investors can use Skype to listen to conference calls through their computers. Skype even provides touch-tone capabilities using the keyboard number pad, so users can fast-forward and re-wind at will as if they were using a normal phone. Ordinarily, listening to the Quest conference call referred to above would have cost me 15 cents/minute, but through Skype the whole call cost me only 50 cents.

Disclosures:

Author has a long position in shares of QCC

Author has no position in Skype or EBAY

What Is Risk?

The mainstream finance industry defines a company's riskiness by its stock price's volatility. For value investors, there is no such short cut; a company's riskiness is defined by a slew of factors that can affect the business. Previously, we have considered some items that can affect risk on the cost side. Today's post will discuss some items relevant to risk on the revenue side.

First of all, a company's revenue can have varying degrees of cyclicality. What this means is, during recessions, certain industries are hurt more than others. Conversely, these industries tend to do better when the economy is strong. Nevertheless, there is higher risk involved in a cyclical business, since poor conditions can persist and cause companies to be unable to meet their obligations. For a more detailed discussion of this topic, see this article.

Secondly, risk is lower when a company has a "moat" (as coined by Buffett) that essentially protects it from competition. In these instances, revenues are more stable, thereby reducing downside risk. Of course, companies with strong moats are hard to come by.

Revenue risk is also reduced when a company is not depedent on one product, as having multiple lines serve to diversify a company's risk should a competitor make inroads or should a product become obsolete. Having a diverse array of customers also helps, since that way a company's fortunes are not tied to the health of companies outside of its control. (This was an important factor when we answered a reader's question on auto parts suppliers a few months ago.)

Finally, it's important to understand how persistent current revenues are. Does the company need to keep innovating just to hold revenues steady, or has it already done most of the work? As an example, contrast Walmart with Apple. Apple's earnings are only as good as its latest products, and it must make sure to keep producing products that customers value, which won't be easy over the long-term. On the other hand, Walmart already has a presence where it can sell the products customers value, without having to innovate anew!

While it's impossible to predict the future, investors can better protect themselves from unforeseen events by choosing companies which are less susceptible to revenue declines. By considering the factors discussed above, downside risks can be reduced.

Small-Caps Rock

Our regular readers have undoubtedly noticed that we have a tendency to discuss small cap stocks quite a bit on this site. Why? Because among the small cap universe some of the most inefficiently priced stocks can be found. They carry little in the way of name recognition for retail investors, and they don't move the dial enough for institutional investors (their budget calculators show that the returns just aren't worth it).

As such, for those who can read/interpret/understand financial statements, small cap stocks offer up some great opportunities. As Charlie Munger stated at the Wesco Financial meeting a few weeks ago:

"Don't go after large areas. Don't try to figure out if Merck's pipeline is better than Pfizer's. It's too hard. Go to where there are market inefficiencies. You need an edge. To succeed, you need to go where the competition is low. That's the best advice I can give to small investors."

But while we've discussed stock investment research sources for individual investors, most of these sources are focused on large caps, as that's where the web traffic's at. One site, however, is devoted entirely to small caps: Agoracom is a site dedicated to providing information and promoting discussion of small cap stocks.

There is one caveat, however. Its business model derives revenue not from advertising, but from the small cap companies themselves. Many small caps struggle to get their names out there to investors, and so they are willing to pay Agoracom to discuss their companies. As such, it is unlikely you will find much in the way of negative information. Nevertheless, investors looking for info on small caps can find discussion forums, filings, quick facts and other useful information that could eventually lead to an investment decision.

If you use or have useful sources for small cap investing, please feel free to share them with others of like mind in the comments section below.

Effecting Change

Which company inspires more confidence in its financial results, one that has had a publicized auditing misstep in the past, or one with a pristine history? Surprisingly, the first company may be more credible. The reason is that for positive corporate governance changes to occur, the problems with poor corporate governance often have to surface. The company that has experienced serious enough issues to take notice, but not so serious that they proved fatal, has been provided a catalyst for change.

Consider Genesis Land Development (GDC), a company we have previously discussed as a potential value investment. The company is preparing for its annual meeting by issuing press releases recommending "that a strong independent slate of directors be elected...to assist with the ongoing efforts to improve governance, oversight and shareholder value".

The release goes on to say that "additional steps must be taken to strengthen governance, management oversight and management itself" and "a strong independent board of directors is critical to the future success of the Corporation".

Of course, a strong independent board is something that shareholders would like to see at many companies, but it is not often made a point of focus by companies with otherwise poor governance.

But GDC has seen what poor governance can lead to. Two years ago, the company's CEO and CFO were dismissed with cause following findings that they misled auditors. As the recession started to threaten the company's viability, the CEO was re-hired and has engineered the company's return to profitability.

However, shareholders have not forgotten the mistakes of the past. Shareholder groups have stated that "it is clear that [CEO] Gobi Singh, with his inexcusable history when it comes to transparency and good governance, needs to report into a strong, independent Board" and that they will put forth an independent slate if the company does not.

This brush with the pitfalls of a poor corporate governance structure has provided Genesis shareholders with the burning platform they need to effectuate positive change. Hopefully, this will lead to a stronger company better able to raise its share price such that it is commensurate with the value of its assets.

Disclosure: Author has a long position in shares of GDC