Book Review: Contrarian Investment Strategies

Contrarian Investment Strategies: The Psychological Edge (2012) by David Dreman

This book provides a great overview of the psychology of investing and how success can be achieved using a contrarian (value-oriented) approach. It is divided into five parts:

• Part I looks at bubbles, panics, and other stock market manias, drawing attention to their common characteristics and showing that they do not change much over time. The author discusses how investor behavior in such situations can be partly explained by psychological findings about how affect (emotion) and cognitive biases influence decision making.
• Part II focuses on the "new dark ages" of investing by giving some history related to the Efficient Market Hypothesis (EMH). The author uses examples of market crashes to challenge EMH assumptions about liquidity, leverage, and volatility. The main conclusion is that EMH does not have much support when it is scrutinized closely and applied to reality.
• Part III examines the difficulties and flaws of market forecasting, demonstrating that analysts and experts are bad at estimating future company earnings and stock returns. There is an interesting quantitative and psychological analysis of how positive and negative earnings "surprises" are related to subsequent stock returns.
• Part IV discusses how investors can find success by following contrarian investment strategies and buying stocks that are out of favor. It is demonstrated that strategies based on (a) low P/E, (b) low P/CF, (c) low P/B, (d) high yield, or (e) low price-to-industry [i.e., a company being undervalued relative to its competitors] all provide superior returns in historical backtesting. The author attributes this success to what he calls the Investor Overreaction Hypothesis (IOH), which is the idea that out-of-favor stocks mired in pessimism tend to become undervalued, but subsequent developments (earnings surprises and fundamental improvement) lead to positive reappraisals that result in regression toward the mean over time. This part also includes an extended discussion of the price-to-industry strategy, commentary on high-frequency trading, and thoughts about risk.
• Part V concludes with commentary about recent market and economic events (e.g., the housing bubble and financial crisis), as well as topics such as free trade and inflation.

Overall, I think the book is an excellent resource for investors. In my review of the author's 1977 book, Psychology and the Stock Market, I noted that he provided "one of the most compelling counterarguments to EMH that I have ever read." In this book he builds an even stronger case against EMH from both psychological and value-based perspectives, showing that it does not fit well with reality. The book should be required reading for anyone who believes in EMH and related ideas, such as Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM). Moreover, anyone who takes a value-oriented approach to investing (as I do) will likely be interested in the analyses of the contrarian investment strategies described in the book.

Note: I read this book in January 2013 and re-read parts of it in May 2013.