Steve Forbes: David, it’s good to have you with us. You’ve been a columnist for Forbes before I was born. 1979?
David Dreman: Yes. I’ve been a columnist here for a long time and very, very much enjoyed it.
Forbes: And you have a new book out called Contrarian Investment Strategies but here’s the kicker, The Psychological Edge. Just out – fresh. First of all, before we get to your methods of investing and your insights, you say this is the best time, that you’ve never seen stocks as cheap as they are today since 1982. Explain. This is good news.
Dreman: The averages are way down. I think back in 2000, the S&P was somewhere around 28 times earnings, and normally it’s probably about 17 or 18. And now, on 2012 earnings, it’s around 14, 15, so it’s very cheap. Companies are strong, cash flow is good, finances are probably the best they’ve been in years.
People are just terrified to go near stocks at this point. These huge outflows, out of mutual funds – $200-$300 billion last year alone – have made people just want to be out of the market because the huge volatility and the belief that this depression-like environment will go on for forever.
Forbes: Talking about earnings, do you see any threat to earnings in 2012-2013 from overseas? I mean, Europe’s going into a recession, Singapore had a bad fourth quarter. We’re moving, but not nearly what we should after severe downturn. Do you think earnings could have a nasty surprise that could upset your scenario? Or do you believe that even if earnings take a nick they’re still so cheap, these companies, that they’re still worth buying?
Dreman: I think I agree with you, what you just said. There could be, it’s hard to fine-tune earnings. And they could take somewhat of a nick because of European operations. But stocks are still very, very, cheap and I don’t think it would be a huge nick. Germany’s holding up reasonably well. We weren’t hurt much by what happened abroad this year. I don’t think we’re going to see foreign trade collapse like it did after 1929. I think there might be some changes, but I don’t think they’ll be very major.
Forbes: Go through, for us, your criteria for investing. Of course P/E ratios, sales too, profits and the like. And then get into some of the new tools you reveal in this new book.
Dreman: Right. Thank you, Steve. Well, we’ve always been contrarian investors.
Forbes: Is that another word for “value,” or do you feel that – explain the difference between contrarian and value.
Dreman: Well, contrarian is a form of value investor, where we tend to buy the lowest P/E stocks, or by P/E ratio, or we can also use price-to-book, or price-to-cash flow or even high yield. There have been studies that go back now as far as the 1930s, and they show that low P/E and low price-to-book have outperformed the market in every decade since, I think, starting with the 1940s.
So it does work. There are a lot of very good stocks that tend to be – people just don’t like them for one reason or another, and they won’t pay much for them. Classic examples were the food companies 20 years ago, or the tobacco companies in the 1990s. You get whole industries – oil and gas – that were very, very, out of favor for many, many years that really had solid growth, strong fundamentals, strong finances, really excellent cash flow and high yields.
So that’s basically the type of stocks we buy. We always have a diversified portfolio, probably 50 to 60 stocks, because we’ll miss something. Everybody’s going to miss some. I think Warren Buffet said, “If you can pick 60%, you’re doing very, very well,” and I think that’s very true.
We have diversification and we don’t take really big bets on any one stock. We try to keep the size of each purchase pretty much the same. If we buy a new company, a new name, we’ll sell another one. We always sell at the market multiple, we buy below market multiple.
But when a stock moves up to the market multiple, we’ll sell it. Or if there’s very bad news, which occasionally happens, we sell immediately. But overall, the strategy has worked well. Unfortunately, it doesn’t work all the time. It’s going to have its bad years, and then some very good ones.
Forbes: So what new metrics and new measures do you have in the book to help you find these contrarian equities?
Dreman: A couple that were always there and we hadn’t used. I guess the most important would be the fact that if a company has a loss, even if we think it’s a short-term loss, we’ll sell it and buy it when the company comes back to profitability. That would have saved a lot of us in the financial crisis, because everybody thought those losses would have been very, very short-term, but they weren’t. So that’s probably important.
Diversification is more important than it’s ever been because we are actually putting our portfolios up to, as I said, 50 or 60 stocks. We actually put together a low P/E index fund, if you will, which is all low P/E stocks. We will have 100, and they’re equally weighted. That’s done reasonably well over time.
Forbes: Now, this index, is it just big-cap, small-cap, a mix? How do you put the mix? And it’s done just numerically? So if a stock doubles, it’s still the same weight as another stock? You don’t do it by capitalization or market value?
Dreman: Actually we have a slew of very low P/E funds. We have small-cap, mid-cap, what they call “smid,” which is small and mid put together, and large-cap. Those are probably our four big ones. And it turns out, over time, that low P/E small-cap has really outperformed everything around, if you go long enough. But there will be periods that could go up to five years or eight years, where it –
Forbes: And small-cap, by your definition, is what?
Dreman: Well, the definition has probably changed very dramatically since 2008. Small-cap was $2 billion in 2008. I think it’s probably around $1.4 billion or $1.5 billion right now. And large-cap has come down from $20 billion to probably $10 billion because the market has really gone down pretty significantly.
Forbes: So among the new measures you say is if you have a loss, just to cut it.
Forbes: In terms of profit. What other ones do you like?
Dreman: Well, I guess some of them are fairly new. They’re psychological. There’s some new psychology out there that really explains bubbles and crashes. It’s called “affect.” And what they’ve found in the research, and this is a psychological research, is the more we like something, the more we’re willing to pay.
And they found that people can pay as much as 100 times what a stock is worth. Which explains, of course, the Internet bubble and probably all bubbles. We get so caught up in ideas, even the professionals, that we tend not to look at the real value of a stock.
Forbes: So we fall in love.
Dreman: Repeatedly. And we never seem to, as a group –
Forbes: Before we get into the – what you call cognitive psychology – what were the lessons you learned from 2008? The banks took a huge hit. What did you come out with that to sharpen your contrarian philosophy, so that if something goes wrong it doesn’t have quite the devastating impact that it did, even though it may be only short-term?
Dreman: Yeah. Well, I guess the rule that if there’s a loss don’t buy it is very, very important. With financial stocks, they’re more difficult than most others to really evaluate because you don’t get good information, even when you talk to senior people at the banks. May not be deceit – they may not know themselves. Because I think some of the very major banks had no idea about how much they owned in subprime.
Dreman: There are a lot of complexities that just don’t show in a balance sheet. You just can’t get to them. So I would probably never go as heavily as we had gone into financial stocks. Banks would be the most complex because the reporting – although legal or certainly accept by the SEC – doesn’t really go into enough detail to ferret out what really is going on.
For example, take a bank like CitiGroup. They didn’t really have a real handle on their loss at all, I think, even near the top. I think the same was probably true with some of the big investment bankers – certainly Lehman Brothers and Bear Stearns before them. The leverage was just, again, was enormous. I think normally, banks, before they got around Glass-Steagall, leverage might have been, say, ten-to-one, 12-to-one. For some of the banks, it got up to 30-to-one. And for the hedge funds, it got up to 35-to-one, 40-to-one. With that kind of leverage and really pretty poor subprime mortgages, a 2.5% drop would wipe out all of the capital. And, of course, the houses didn’t go two 2.5%, they went down 34%.
Forbes: So even today, you wouldn’t buy a Citi or a Bank of America – or just fewer shares?
Dreman: Probably fewer shares. And also, I think today I’d buy the banks that the government has almost put their stamp of approval on.
Forbes: Like Wells Fargo?
Dreman: Wells Fargo, yes. Wells Fargo and Morgan Stanley, Fleet’s another one that came up stronger than most of the U.S. bank core. Stocks of that ilk. We probably have smaller positions, but we certainly look at them here.
Forbes: That gets to what some of the companies and industries you like are. Before we get to oil and gas, which you seem to like, what are some of the other companies? You’ve written in the past about Allstate, United Technologies. What are some of the favorites on your list?
Dreman: United Technologies is a conglomerate – they don’t use that wording, “multi-divisional company.” But it’s been very profitable over a very long period of time with Otis Elevator, jet engines, and I think they’re moving into other areas. And I think they’ve shown earnings growth of 10%, 12% a year. Even through the bad times, they still had up earnings, the bad times being the last few years.
The P/E is fairly modest on that, it was down at 14 times earnings, or something like that. So that’s the kind of stock we like. We also have a belief that a few years out, when employment – even if it’s gradual – we’ll get down to 7.5%, possibly 7% unemployment. We’ve printed $7 trillion. We’ve doubled the debt since 2008. There’s a lot of money floating out there, not only in the United States, but elsewhere. And we think that we’re going to probably face some inflation for, at most, four or five years out.