By Joseph Dancy

Joe Dancy writes for the Lone Star Growth Investor newsletter. The newsletter is free of charge and is delivered to subscribers via email on a regular basis. For additional subscription information, you may visit their web site at: http://members.aol.com/LSinvestor

September 7, 1998

LONG-TERM VALUE BASED STRATEGIES OUTPERFORM STUDIES SUGGEST
Well known money manager David Dreman recently published "Contrarian
Investment Strategies: The Next Generation" - an interesting book packed full
of studies and statistics to support his argument that value investors
outperform over time.

Dreman: Contrarian Investment Strategies
While some have noted it is a small step from being a "contrarian" like Dreman
and being wrong, Dreman's High Return Equity Fund three-year return was 35.4%
and his five-year return beat the S&P 500 (see: http://members.aol.com/lsginvest/art208).

One of the more interesting points documented by Dreman in his book is his
claim that analyst forecasts are inherently unreliable - analyst errors have
made earnings "surprises" extremely common. Dreman's studies indicate that
only 47% of analyst quarterly estimates were within plus or minus 10% of the
actual results, and between 1973 and 1996 the average error was 44% on an
annualized basis. He also noted that such errors continue to exist in the age
of internet access to a mountain of information.

Reviewing 90,000 earnings estimates, Dreman found the chances of a company
going four consecutive quarters - one fiscal year - without a negative
earnings surprise are one in seven. Over 10 quarters - 2 1/2 years - the odds
for avoiding a negative surprise are one in 140. And over a five-year period,
the odds of avoiding a negative surprise fall to one in 20,000.

Street analysts are well qualified, but non-the-less Dreman found the end
product is badly flawed due to industry pressures, market complexity, and
unforeseen and unpredictable internal and external events. No surprise here.

Investor Overreaction
Due to the degree and large number of analyst errors Dreman concludes most
forecasts should not be relied on - but he notes that these errors can be used
to an investors' advantage. Dreman's studies show that the impact of positive
earnings surprises on out-of-favor stocks (stocks with low price/earnings,
price/sales, or price/book values) influence their price much moreso than
those of higher valued stocks. For 500 large companies between 1973 and 1995
low P/E stocks rose an average of 5.7% in the year following a positive
surprise, while high P/E stocks rose only 0.5% on such news.

Further, Dreman found negative news has little influence on out-of-favor
companies. Such news generally has a significant impact on higher valued
companies. Dreman's research shows that low price/earnings stocks fell only
0.5% in the 12 months following a negative surprise, whereas the popular high
price/earnings stocks fell 7.4%.

This reaction to surprises is rooted in psychology according to Dreman, with
investors tending to overreact to good or bad news. This overreaction is
especially evident in the technology sector and in small capitalization
stocks. Dreman currently considers technology stocks like America Online and
Yahoo to be overpriced based on overly optimistic forecasts (that are also
likely to be wrong) - "forecasts often have to go out a decade or more to
justify the high prices many companies are trading at."

Dreman believes AOL's current valuation will require a 50% earnings growth for
the next 18 years. To deliver those kinds of profits, Dreman estimated that
AOL will need to increase its customer base during the next 18 years from
about 12 million subscribers today to about 18 billion, or more than three
times the current global population.

As for Yahoo, Dreman crunched the company's numbers on the assumption that its
earnings would grow at an incredibly furious rate during the next 25 years.
Even in that rosy scenario, Dreman assigned a $4 value to Yahoo's stock. The
company is trading at $77 at the beginning of September.

Re-Defining Risk
One of the other interesting chapters in Dreman's book deals with the concept
of risk. Traditionally risk has been defined as volatility - measured with
beta coefficients or standard deviation. The more volatile a stock, the more
inherent risk the stock carries according to commonly accepted market
theories.

There are two problems with volatility. First, it frightens investors into
selling when they shouldn't. Second, it means you shouldn't hold a portfolio
highly weighted toward stocks if you might need to sell any time soon to
obtain the cash value.

Dreman claims that the use of volatility as a measure of risk is not entirely
appropriate - that since World War II a much larger risk to the investor has
been inflation and taxes. Ignore inflation and taxes, and the purchasing power
of invested monies can quickly decline.

He also believes risk measurements should be taken over longer-term periods
than beta and standard deviation, which generally are calculated on one-year
periods. Dreman's comments on this issue are similar to Warren Buffett's,
another value investor. Buffett has noted that when using beta measurements a
stock that has dropped very sharply relative to the market would become
"riskier" at the lower price than it was at the higher price
(see:http://members.aol.com/lsginvest/art226).

Dreman's studies indicate over time stocks have been a better avenue of
preserving purchasing power than low-volatile bonds or T-bills. "The
conclusion," writes Dreman, "is obvious . . . Using this analysis of risk in
the postwar period, stocks are the least risky investments over time."

Small Cap Studies
Dreman also argues that studies of the outperformance of small stocks over
time are flawed. Many smaller stocks are not liquid, so studies of their price
movements are not indicative of what could be achieved in the real world. The
bid-ask spread of many smaller stocks make them much less attractive once
spreads are included in the studies.

Note that "buying small companies does give you higher returns" according to
Dreman, but only if undervalued - low price/earnings, price/book, or
price/cash flow - small cap stocks are selected. These out-of-favor companies
will outperform more fully valued small and larger cap stocks according to his
studies.

With regard to smaller cap stocks Dreman thus recommends buying value based,
out-of-favor companies. He notes that due to the trading costs - commissions
and above normal bid-ask spreads in this sector are usually very large -
around two to three times that of S&P 500 companies. Such spreads can quickly
erode an investor's advantage gained by investing in undervalued companies in
this sector - unless trading is kept to a minimum.

Anotherwords, Dreman's studies suggest a buy and hold, small-cap, value-based
investment philosophy will increase the probability that a portfolio will
outperform the market.

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