Contrarian Investment Rules

Extracted from Contrarian Investment Strategies by David Dreman

  1. Do not use market-timing or technical analysis.
  2. In-depth information does not necessarily translate into in-depth profits as it is difficult to work with a mass of information.
  3. Do not make an investment decision based on correlations.
  4. Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.
  5. There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble.
  6. Analysts’ forecasts are usually optimistic. Make the appropriate downward adjustment to your earnings estimate.
  7. Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.
  8. It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past to estimate the future.
  9. Be realistic about the downside of an investment, recognizing our human tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.
  10. Take advantage of the high rate of analyst forecast error by simply investing in out-of-favour stocks.
  11. Positive and negative surprises affect “best” and “worst” stocks in a diametrically opposite manner.
  12. Surprises, as a group, improve the performance of out-of-favour stocks, while impairing the performance of favourites. Positive Surprises result in major appreciation for out-of-favour stocks while having minimal impact on favourites. Negative surprises result in major drops in the price of favourites while having virtually no impact on out-of-favour stocks. The effect of an earnings surprise continues for an extended period of time.
  13. Favoured stocks underperform the market, while out-of-favour companies outperform the market, but the reappraisal often happens slowly.
  14. Buy solid companies currently out of market favour, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.
  15. Don’t speculate on highly priced concept stocks to make above-average returns. The blue-chip stocks that widow an orphans traditionally choose are equally valuable for the more aggressive businessman or woman.
  16. Avoid unnecessary trading to eliminate excessive transaction costs.
  17. Buy only contrarian stocks because of their superior performance characteristics.
  18. Invest equally in 20 to 30 stocks, diversified among 15 or more industries.
  19. Buy medium or large-sized stocks on NYSE or only larger companies on NASDAQ.
  20. Buy the least expensive stocks within an industry, as determined by the four contrarian strategies. (low PE, P/BV, P/CF, P/D)
  21. Sell a stock when its PE ratio (or other contrarian indicators) approaches that of the overall market and replace it with another contrarian stock.
  22. Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in a markedly different outcome.
  23. Don’t be influenced by the short-term record of a money manager, broker, analyst, or advisor. Don’t accept cursory economic or investment news without significant substantiation.
  24. Don’t rely solely on the “case rate”. Take into account the “base rate” – the prior probabilities of profit or loss.
  25. Don’t be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the “case rate”). Long-term returns of stocks (the “base rate”) are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.
  26. Don’t expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.
  27. The push toward an average rate of return is a fundamental principle of competitive markets.
  28. It is far safer to project a continuation of the psychological reactions of investors than it is to protect the visibility of the companies themselves.
  29. Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell.
  30. In a crisis, carefully analyze the reasons put forward to support lower stock prices – more often than not they will disintegrate under scrutiny.
  31. Diversify extensively. Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.
  32. Volatility is not a risk.
  33. Small-cap investing:
    • Buy companies that are strong financially (normally no more than 60 percent debt)
    • Buy companies with increasing and well-protected dividends that also provide an above-market yield.
    • Pick companies with above-average earnings growth rates.
    • Diversify widely
    • Be patient, nothing works every year.
  34. Small-company trading: Don’t trade thin issues with large spreads unless you are almost certain you have a big winner.
  35. When making a trade in small, illiquid stocks, consider bid/ask spread.
  36. Avoid the small, fast-track mutual funds.
  37. A given in markets is that perceptions change rapidly.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s