Some stocks are like Charlie Brown's Christmas tree. All they need is a little love.
Contrarian investing is about identifying stocks that have fallen out of favor and are priced low relative to the companies' profits. The investor has to ignore the impulse to flee and see the stock for its potential.
David Dreman, who helped popularize the idea of contrarian investing as an investment manager and magazine columnist, believes behavioral psychology plays a hand in the markets, mostly in the form of an overreaction to events. Look at the plunge in the indexes immediately after Britain voted to leave the European Union last summer, for example. Markets were back to all-time highs within weeks and have since continued to set new highs, even with the surprise election of Donald Trump to be the next president, something for which people had expected a negative market move.
Emotion means there are often expensive, high-flying stocks that are overhyped and plenty of cheap stocks that are ignored because they are underperforming. Over 30 years of research, Dreman Value Management found that buying stocks of financially strong companies that are currently out of favor pay off down the road in the form of higher prices once the market recognizes the error of its ways.
Such deep-value stocks stand out for their low price-to-earnings ratios and above-average yields.
Of course, the challenge with this approach is that a contrarian often finds himself alone. Dreman's website explains the firm's philosophy: "The popular thing to do is often not the smart thing to do." When everyone is piling into the hot stock of the moment and driving it into overvalued territory, the best course may be finding the hidden gems.
It also means moving into uncharted waters. These days, it could be contrarian just to be concentrated in a few holdings, rather than doing what seemingly the whole world is doing by broadly diversifying across multiple asset classes. It could mean betting on companies that are sensitive to rising interest rates, or picking sectors or geographies that were once fast-growing but have cooled off. It could mean going underweight on a group others are seeing as potentially big winners in the next year.
This year, investors started out defensive and gradually shifted to cyclical stocks as it became clear markets and the economy saw growth ahead. Trump's plan to emphasize infrastructure projects to add jobs and boost development is benefiting stocks of U.S. materials and construction supply companies and heavy equipment makers. The contrarian might look to utility and financial stocks just to be different.
My Dreman-based model is made up of multiple valuation and financial strength criteria. The strategy, which is based on Dreman's book, Contrarian Investment Strategies, is one of the more rigorous value strategies I run on Validea.com, and after a few difficult years, the performance of a 10-stock model portfolio that holds the top-rated contrarian stocks is up 32.4% year to date through Dec. 7, compared to 9.7% for the S&P. The model is composed of the following investment criteria and below are three stocks that pop up on our screen of the top contrarian picks.
- Market cap: Company should be in the largest 1,500 companies in the entire market.
- Earnings trend: A company should show a rising trend in the reported earnings for the most recent quarters.
- EPS growth rate: Look for companies with an EPS growth rate higher than the S&P 500 in the immediate past and future.
- Stocks need to pass at least two of the following four major value criteria:
- Price/earnings ratio (P/E): P/E of a company should be in the cheapest 20% of the overall market.
- Price/cash flow (P/CF) ratio: P/CF of a company should be in the cheapest 20% of the overall market.
- Price/book (P/B) value: P/B of a company should be in the cheapest 20% of the overall market.
- Price/dividend (P/D) ratio: P/D of a company should be in the cheapest 20% of the overall market.
- Current ratio: The current ratio must be greater than or equal to the average of its industry or greater than 2.0.
- Payout ratio: A good indicator that a company has the ability to raise its dividend is a low payout ratio.
- Return on equity: ROE should be greater than the average of the top one-third of ROEs from among the 1,500 largest stocks.
- Pre-tax profit margins: Wants pre-tax profit margins of at least 8%; anything over 22% is considered phenomenal.
- Yield: Dividend yield equal to or greater than the market's yield.
- Total debt/equity: The D/E ratio should not be greater than 20% or should be less than the average debt/equity for its industry.
Enel Generacion (EOCC) -- Chile's largest electrical utility recently traded at all-time lows. But a long restructuring of its Latin America operations is completed and a new listing on the NYSE could give it fresh attention from new investors. Its price-to-earnings ratio is 9.8 while it yields 4.9%, more than the 2.68% for the market.
Chimera Investment (CIM) -- Real estate investment trusts are sensitive to rising interest rates, and hiking short-term rates is exactly what most people expect the Federal Reserve will do. Its P/E is 7.3 and it has healthy 11.6 yield.
Banco Bilbao Vizcaya Argentaria (BBVA) -- Banks in some parts of Europe, such as Italy, are reeling under bad debts. But Spain's banking sector is further along, and BBVA could be poised for a rally. Its P/E is 11 while its yield is 6.4.