Contrarian investment strategy: the psychology of stock market success
Summary
Dreman's first book set out the contrarian value approach he developed over a long career, arguing that stocks with low expectations outperform because analysts and investors systematically overestimate the prospects of favoured companies and underestimate those of disliked ones.
His evidence is empirical. Dreman analysed analyst earnings forecasts and found that consensus estimates were wrong by large margins on average, that the errors were biased optimistic, and that the errors were largest for the companies with the highest expectations. From this he argues that the low price-to-earnings, low price-to-book and low price-to-cash-flow deciles outperform, and that the mechanism is the surprise effect: when a favoured company misses, the disappointment is large because the expectation was high, while a disliked company that beats produces a large positive reassessment.
He was among the first practitioners to build a value approach explicitly on behavioural evidence rather than on Graham's balance sheet logic, drawing on Kahneman and Tversky's work while it was still new.
The book is from 1979 and Dreman restated and updated the argument several times, most fully in Contrarian Investment Strategies: The Next Generation. The empirical work has been superseded by the academic value literature that followed, and the underperformance of price-to-book screens since the mid-2000s complicates the specific criteria. The analyst forecast error evidence and the surprise mechanism have held up.
Key takeaways 7
- Analyst consensus earnings forecasts are wrong by large margins on average and the errors are biased optimistic.
- Forecast errors are largest for companies with the highest expectations, which is what makes those companies dangerous to own.
- Low price-to-earnings, price-to-book and price-to-cash-flow stocks outperform because their prices impound expectations that are too low.
- A favoured company that misses expectations falls further than a disliked company that misses, because the expectation embedded in the price was larger.
- Positive surprises at disliked companies produce large reassessments, which is where a substantial share of contrarian returns comes from.
- Investors extrapolate recent performance into the future, which is the psychological mechanism that creates the mispricing.
- A contrarian approach requires holding positions that are uncomfortable by construction, which is why the return persists rather than being arbitraged away.
Who should read it
Value investors who want the behavioural evidence for contrarian criteria, in the original statement of an argument the author later updated.
About David Dreman
Founder and chairman of Dreman Value Management and a long-running Forbes columnist.
Contrarian Investment Strategies documents the long-run return advantage of low price-to-earnings, price-to-book and price-to-cash-flow stocks across decades of data, and attributes it to systematic forecasting errors by analysts rather than to hidden risk. The work supplies both the evidence base for contrarian portfolios and the operating rules they need, including sell discipline and position limits.
Where it sits in the reference 2
Who recommended it 1 · 1 direct
Similar books 6
Chosen by shared topics, the entries that hold them, and the people who recommended both.
