Search for Deep Value, Not Flashy Overbought Stocks

 | Oct 03, 2017 | 8:00 AM EDT
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Investors seem complacent about this long bull-run market, lulled by low volatility and major indexes that continue their climb upward seemingly impervious to news.

Some have argued that stocks are too expensive, especially the handful of big technology companies that are dominating headlines lately and driving the indexes higher.

The contrarian investor David Dreman, author of "Contrarian Investment Strategies: The Psychological Edge," says investors give high-flying glamour stocks -- which tend to include tech stocks -- too much attention. They allow emotion to overvalue these stocks and ignore or overlook cheaply priced stocks of companies that may be going through some short-term but fixable problems.

This tendency to overreact, and to see stocks as "good" or "bad," is what prevents investors from following simple strategies that could help them beat the market, Dreman says. The temptation to invest in hot stocks is simply too great.

This is especially true when anxiety is running high. Investors shift into a herd mentality. Investors lose sight of how expensive a stock has gotten, they just buy it convinced it will continue to increase in value. They lose the ability to recognize the risk they are taking, and they overestimate how long a positive event will affect a company or its stock.

Take a look at what Amazon (AMZN) has done to retailing and grocery stocks.

The e-commerce giant has surged 27 percent this year, while the Retail ETF (XRT) is down more than 5 percent and the grocery and specialty food ETF (PBJ) is down more than 3 percent. People are worried Amazon is going to eat brick-and-mortar stores alive (especially after its acquisition of Whole Foods Market). Wall Street analysts are fanning the flames, too. An analyst recently slapped a $1,400 price target on Amazon shares, which are currently trading around $1000.

A deep value investor would look past the glamorous Amazon and see other opportunities.

Validea's model tracking deep value guru Benjamin Graham recently added shares of Foot Locker (FL) , the athletic apparel retailer whose shares have fallen 28 percent this year.

Jim O'Shaughnessy has also studied this psychological phenomenon. Individual and professional money managers tend to stick with a manager for three years and dump that manager for underperformance rather than staying the course. O'Shaughnessy cautions that no one manager can beat the benchmark over a sustained period of time, and that the very best ones tend to underperform for a period before rebounding strongly.

The same can be said for investment strategies. They're not all going to beat the market all the time. At Validea, we have a portfolio that tracks Dreman's investment style. Not surprisingly, a contrarian style struggled somewhat with a run up in the market, but it has gained ground lately. So far this year the 10-stock portfolio is up 18 percent versus the 12 percent gain in the S&P 500.

What is Dreman's strategy? He looks at four financial variables that measure the health of a company's operations: earnings, cash flow, book value and dividend yield, and compares them to the company's stock price. Because he's a contrarian looking to follow the path less trodden, he sorts stocks into buckets, choosing to focus on the lowest 20 percent of the market. The model then applies a series of additional financial tests that looks for businesses that appear to be improving.

The whole idea here is that what goes up comes down, and what goes down will revert to normal eventually. It sounds incredibly simple and that's the idea of deep value investing. Buy stocks that no one else wants to own and you will find some winners.

Park Hotels & Resorts (PK) -- Is the owner and operator of hotel properties around the world. Given the stock's rock-bottom valuation, the shares are in the lowest 20% of all stocks based on the P/E, P/B, P/CF and P/Dividend.

AT&T (T) -- Dreman's strategy looks at a company's stock price relative to its operating cash flow. If it's low, the stock may be undervalued. Telecommunications giant AT&T has a price-to-cash flow measurement of 6.25, putting it in the bottom 20 percent of the market.

Enel Generacion Chile (EOCC) -- The Chilean power generating company could be a way into the very downtrodden energy sector. The Dreman model measures its price-to-dividend at 14.8, again putting it at the bottom 20 percent of the market.

Large and mid-caps, and non-US stocks (via ADRs) are well represented in the top ten list of stocks that score highest under the Dreman Contrarian Investor model. See names below.

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