If there’s one quote that would describe contrarian investing it would have to be the following:
Be fearful when others are greedy and be greedy when others are fearful-Warren Buffett
It is easy to understand but few will follow through once crisis hits such as the current credit crunch. In his classic book Contrarian Investment Strategies: The Next Generation, David Dreman devotes a whole chapter on how to profit when blood hits the street.
Know Your Enemy
All throughout the book, David Dreman introduces the reader investment rules to follow and this chapter was no exemption as chapter 12 included 3 rules starting with number 29.
Rule 29: Political and Financial Crisis lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell.
If one can somehow shutoff the noise on Wall Street, you have the oppurturnity to make make major gains. According to David Dreman, holding stocks for two years after a crisis resulted in spectacular returns (263).
Symptoms of A Crisis
How does one know when a crisis has arrived?
The symptoms of a crisis are anything but hard to find, and usually are downright unavoidable
-p.264
If your CNBC, you check how the DOW is doing every 10 seconds. I have found that people who could not tell the difference between a stock and a stick become interested in the market. Also, the list of stocks hitting 52 week lows tend to get longer. In addition, the magic formula screen will churn out the full results. When the market kept making new highs (remember that?), very few stocks appeared using the magic formula stock screens. Also, check out industry returns for a certain period. For examaple, looking at this chart, one could see the home construction and mortgage finance indexes are down greater than 50% from one year ago.
Rule 30
In a crisis, carefully analyze the reasons put forward to support lower stock prices-more often than not they will disintegrate under scrutiny.
Essentials for Crisis Investing
Contrarian Investment Strategies: The Next Generation, was published in 1998, less than a decade removed from the Savings and Loans crisis of 1990. At the height of the crisis most banks were trading at 50% off their market values a couple of months earlier. Also, most banks were priced at discounts to their book value. David Dreman used different criteria to increase his odds of his holdings not going under.
Buy Financially Sound Banks
In today’s market, this would equate to one avoiding the likes of E-Trade Financial, Countrywide Financial and American Home Mortgage to name a few.
Buy Banks With Adequate Capital
In his book Beating The Street, Peter Lynch used Equity-to- Assets Ratio to insure a bank had enough capital to survive the same S&L crisis. For example, US Bancorp (USB) currently has an equity-to-assets ratio of 9.08%. Most banks have an average equity-to assets ratio of 8% but anything over 6% will do.
Pay Attention To Financial Ratios
Most banks will trade well below book value during a crisis. Doing some security analysis will help determine whether book value reflects real value. The higher quality banks like Wells Fargo and US Bank will trade at or below historical low levels. I have found banks with high ROE have better staying power.
Hedging Your Bets
Crisis brings enormous opportunity, but there is always the fear something will go wrong
-page 268
Although banks can currently look undervalued, it is no guarantee your bets are safe. For example, many investors flocked to Delta Financial Corp. (DFC) figuring if Mohnish Pabrai bought at X, it is a steal at $3. Those investors were greatly disappointed as Delta Financial Corp. filed for bankruptcy. The best way to guard against negative surprises is to spread ones bets (diversify). The Garcia Value Fund currently holds 8 financials. Worst case scenario, Vineyard National Bancorp goes bankrupt. Best case scenario, all financial holdings rebound nicely.
Value Lifelines In A Crisis
According to David Dreman, the common denominator in all crisis is a sharp drop in prices caused by serious investor overreaction. With this comes a shrinking of financial ratios. For example, in 2004 Well Fargo Corp (WFC) finished the year with a P/E of 14. Currently, Wells Fargo has a P/E of 10 with a forward P/E of 9.
Rule 31
(A) Diversify Extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clunker.
(B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.
Disclaimer: I own US Bancorp (USB)
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