A Value Guru Retires

Published in Investing on 29 October 2010

Value guru David Dreman takes it easy.

This weekend sees an important but largely overlooked event in the world of value investing -- the retirement of David Dreman as Chief Investment Officer of Dreman Value Management.

While he is not so well known this side of the Atlantic, Dreman has a dedicated following within the American value investment community, and his company now manages assets of $5bn.

Contrarianism

Dreman is best described as a large-cap contrarian investor, which means he looks for strong companies whose shares have been beaten down by fear or apathy.

In his quest for out-of-favour companies, Dreman emphasises four main ratios:

  • the P/E ratio;
  • price to book;
  • price to cash flow; and
  • dividend yield

By finding the cheapest shares on each of these measures, he tries to identify the companies whose profits, assets, cash flows and dividends are least appreciated by the market. 

According to the theory, our human propensity to over-react means that these unloved shares are excessively shunned by the market, and for that reason we can pick up their shares at bargain prices.

Efficient Markets

As a contrarian, Dreman is particularly critical of the efficient market hypothesis (EMH), and of its sibling, the capital asset pricing model (CAPM): "I make my living investing in market inefficiencies."

He recently said "it's time to delete the CAPM from business school textbooks", and went on to blame it, and the models it spawned, for all the major crashes over the past 30 years. Its main academic flaw, he believes, is its assumption that liquidity will always be available, while he also criticises it for ignoring investor behaviour.

Psychology

"Psychology is probably the most important factor in the market, and the one least understood. There's constant over-reaction in the market", he explains, and it is this over-reaction, rather than any market 'efficiency', which results in opportunities to buy and sell.

In his books (see below), and as co-editor of The Journal of Behavioral Finance, Dreman has contributed to investors' appreciation of the role of psychology in the markets.

The crash

Psychology was not the sole cause of the current financial crisis, of course, and Dreman has examined its causes and effects in detail. 

Among the long lost of culprits were the Clinton administration for pressurizing Fannie, Freddie and the banks to issue more loans to lower-income families, and for repealing the Glass-Steagall Act; Federal Reserve chiefs Greenspan and Bernanke for keep interest rates far too low; and financial institutions in general for ignoring risk.

"Congress and several administrations made serious policy errors, that make Herbert Hoover's economic advisers almost look like superstars next to Bernanke, Paulson, Geithner and Summers."

But we shouldn't ignore the fact that Dreman's funds did particularly badly during the crisis, as they were heavily exposed to the financial sector, which many incorrectly considered to have been deeply into value territory.

To help avoid similar crashes in future, Dreman advocates a back-to-basics approach: 

"The New Testament of investing is actually a return to the Old Testament. I'm talking about Ben Graham and David Dodd's Security Analysis, first published in 1934. They warned investors to stay away from excess leverage, illiquidity and other risks that CAPM ignores."

Predictions

Dreman's big concern over the medium term is inflation, as governments continue to print their way out of the problem: 

"I think we [in the US] will have 10-12% inflation once unemployment comes down below 6% which could be another 4 years or so. There is no question there will be higher inflation in the future."

For that reason, he says "housing with leverage will be an excellent investment". It's important to point out that he is referring again to the US, where average house prices have been allowed to correct by 30% from the peak.

As regards shares, in his most recent Forbes column, he was positive about tobacco giant Altria at $23 (now $25.29), oil and petrochemicals company ConocoPhillips at $54 (now $59.23), and 'big pharma' Pfizer at $16 (now $17.38).

He will be succeeded as Chief Investment Officer at Dreman Value Management by E. Clifton Hoover, who joined Dreman in 2006, but he will continue to chair the company, and to manage the Dreman High Opportunity Fund and the Dreman Market Overreaction Fund.

Like the companies he targeted, Dreman has arguably not yet been given the rating he deserves, at least in this part of the world.

Books by David Dreman:

More from Padraig O'Hannelly:

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

jaizan 29 Oct 2010 , 10:00pm

Most importantly of all, how has he performed against the appropriate benchmark indices over 5 years, 10 years and preferably 20 years?

If there's outperformance in each 5 year period, I might even buy the books.

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