DON’Ts and DOs
From Legendary Stock Picker
David Dreman

In his four decades on Wall Street, money manager David Dreman has made contrarian investing—going against the herd to find cheap stocks—an art form. His five-year annualized return is more than 12 percentage points ahead of the S&P 500 Index.

Here are the “dont’s” of investing that, in Dreman’s experience, lead investors astray—and what to do instead.

Don’t follow the crowd. You would think that investors who got burned when the dot-com bubble burst would know better than to follow the crowd. Yet investors seem to be doing it as often as ever, buying what their friends and colleagues recommend or what is touted on cable business-news channels.

One recent example is the “China play.” Investors are flocking to natural resource funds and stocks in such industries as coal and aluminum based on the notion that China’s demand for raw materials will inflate prices. In reality, most natural resource stocks are down from their peaks, and they are likely to remain that way for some time.

Investment do: Instead of buying stocks or funds just because everyone else is buying them, focus on value. The stock funds that have made the most money over the past 10 years—and over longer periods as well—have been value funds, which aim to buy stocks that other investors ignore (see chart)

Buy stocks or funds with price-to-earnings ratios (P/Es) in the bottom 20% of the market. Today, that bottom 20% figure would work out to an average P/E of 14. Value stocks in general are priced at close to their historical average P/E, but in some sectors such as banking, stocks are selling for much less.

Don’t look for a quick profit—it takes time for value stocks to turn around. But once they do, they keep generating gains for years. Also, the more stocks you own for the long term, the less you will pay in brokerage commissions and capital gains taxes, since taxes are lower for stocks that are held for longer than one year.

Don’t judge a stock fund on less than five years of performance. Funds frequently boast of their superiority based on performance figures that go back three years, but that is too short to create a meaningful record.

Lots of funds had marvelous three-year records because of the technology bubble in the late 1990s. After the bubble popped in 2000, those records stopped looking so marvelous.

Investment do: Look at performance records going back at least five years—10 years is even better. It takes a full market cycle, with both up and down periods, for managers to show their mettle. The longer a manager’s record of beating his/her benchmark, the more confidence you can have.

Don’t believe that big risks produce big gains. Modern portfolio theory may have won a Nobel prize in 1990 for its creator, William F. Sharpe, but its premise — the way to earn a higher return is by investing in a more volatile security—hasn’t stood the test of time.

In fact, research by professors Eugene Fama and Kenneth French of The University of Chicago in 1992 showed no correlation between high volatility— as measured by beta, a commonly used measure of relative risk—and return. (The S&P Index has a beta of one. Any stock with a beta higher than one is more volatile than the index. Stocks with lower betas are less volatile.)

Investment do: Instead of trying to juice returns by buying risky stocks such as technology or biotech shares, improve returns by doing your homework. Look for a history of steadily rising earnings and balance sheet strength—robust cash flow, a debt-to-equity ratio below 50% and a history of dividend increases.

Don’t choose a team-managed stock fund. The idea of having a team of specialists instead of one person managing your money sounds appealing. A team will pool its ideas to make better investment decisions.

In fact, team management isn’t an effective approach for mutual funds. Figures from fund-tracking service Morningstar, Inc., identified a dozen team-managed value funds with track records of at least 15 years. None had performance rankings among the top 10 during that period. All of the top-performing value funds had individual managers.

Investment do: Pick funds with individual managers who have top long-term performance records.

VALUE STOCK PICKS

Today’s stock market is unusually tough, with few intriguing companies available at reasonable prices. Here are the most promising sectors today, with my specific picks ...

Oil: Global demand for oil is gradually overtaking supply—a different situation than in the 1990s, when there was a glut. Oil prices are likely to continue to rise over the long term. My favorite stocks ...

Burlington Resources Inc. (BR). Oil and gas exploration firm. Recent share price: $55.40.

Chevron Corp. (CVX). International oil giant operating in 180 countries. Recent share price: $56.69.

ConocoPhillips Inc. (COP). The largest US-based integrated oil and gas company. Recent share price: $58.21.

Occidental Petroleum Corp. (OXY). Oil company with extensive reserves in the US and overseas as well as a major chemical business. Recent share price: $78.96.

Pharmaceuticals: This industry has had several rough years, marked by major lawsuits and a dearth of new blockbuster products. Some pharmaceutical and health-care services stocks are poised for comebacks. My favorite stocks now ...

Becton, Dickinson and Co. (BDX). This medical technology company is one of the largest makers of diagnostic devices and lab equipment. Recent share price: $51.27.

Medco Health Solutions, Inc. (MHS). Provides drugs to managed-care organizations through its network of retail pharmacies and mail order. Recent share price: $53.32.

Pfizer Inc. (PFE). This pharmaceutical company was hurt when safety concerns were raised about such drugs as Celebrex and Bextra, but given Pfizer’s strong financials and substantial earnings, the stock sell-off was overdone. Recent share price: $28.52.

Wyeth (WYE). One of the world’s largest pharmaceutical companies, with consumer brands that include Advil, ChapStick and Preparation H. Recent share price: $42.75.

Banks: With interest rates moving higher, prices of bank stocks have gone down significantly, creating real bargains. My favorite stocks now ...

Bank of America Corp. (BAC). Mergers have turned this regional bank, based in Charlotte, North Carolina, into one of the biggest banks in the US. Recent share price: $46.75.

National Bank of Canada (NTIOF). This bank has 500 branches in Canada, mostly in Quebec. Its price has tripled in recent years, but it still is a cheap stock. Recent share price: $44.43.

Washington Mutual, Inc. (WM). This Seattle-based company is the nation’s largest savings and loan. It had problems in 2004 when rising interest rates cut into mortgage lending faster than the company could cut expenses. Those problems seem to be under control now. Recent share price: $40.41.

Bottom Line/Personal interviewed David Dreman, chairman of Dreman Value Management, LLC, a money management firm in Jersey City. He is manager of Scudder-Dreman High Return Equity Fund (KDHAX, 800-621-1048), a large-cap value fund. For the five years through May 31, 2005, the fund returned 10.9%, vs. (1.9%) for the S&P 500 Index. He is author of Contrarian Investment Strategies: The Next Generation (Simon & Schuster).