Feb 21, 2009
David Dreman: Exclusive Interview with the Dean of Contrarian Investing (Part II)
By Andrew Mickey, Q1 Publishing
Is Now the Time to Buy Stocks?
Andrew Mickey: Times are tough. But they’ve been bad, downright horrible, many times before. One of the worst times was in the early 80’s when you were making some bold (and correct) moves.
So what investment strategies are you using now? And how is the global crisis and credit contraction impacting your strategy moving forward?
David Dreman: Basically it’s a value strategy. So I’m always looking for value. And what I would want to own now is stock. All stocks are cheaper. But they’re reaching extremely cheap levels.
The markets are probably cheaper than maybe in the 1950s. In the 1950s I think, the Dow was maybe 300, 400, something like that - maybe 500. Then it went to 1500.
So, I mean there is huge upside.
I think this is probably a good time to start nibbling and just buy over a period of time.
Andrew Mickey: We’ve been recommending the same thing and stick to a few sectors which have some long-term life in them. What sectors are you looking at now?
I would probably want to buy companies that could rebound sharply. I was going to buy banks; for example.
They will come back at some point. It’s essential to the economy.
We need a banking system we’re confident in. We can’t work without a banking system. We can patch it up for a while and the government will probably take some stake in a lot of these banks they already had, but we need a banking system.
So I would buy banks. I wouldn’t buy one bank or two banks though; I would buy a bank index.
The market weights all the banks in the country. So usually the biggest ones have a huge impact on the index.
There is one called the KBW Regional Bank Index which can be bought through the SPDR KBW Bank Index Fund (NYSE:KBE). It was around 45 or 50 for a while and hit highs of around 60 over a year ago. Today it’s trading at around, I think it’s around 14 or 15.
Now it’s all measured by market cap. So your biggest stocks, I guess the biggest companies, would be Morgan Stanley, Wells Fargo, some of the major insurance companies, (three or four big shots) and they are probably 15% of the index of other banks.
That’s the way for an investor to get in and not have a lot of risks of any one bank. There is another index called the XLF which is an ETF that measures all the financial stocks in the S&P.
So you have diversification there and the bank industry is way down. But if you stay diversified and it’s a really good index because when finances come back I think this could yield double or triple.
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Andrew Mickey: A double or a triple? Those are expectations no one is saying for the banking sector now. Are there any other ways of playing the financial sector?
David Dreman: It will take time and, again, you need a lot of diversification.
In other words, you don’t want to take a rifle and shoot here. You really want to shoot at the sector with a shotgun because it’s more spread out. That way you’ll have a diversified portfolio of these stocks. So that’s one way.
Another way is to buy companies that are very self-sufficient. You’ve got to find the ones which really don’t need much credit. Because even the best, the companies that never had problems with credit are having problems now.
General Electrical was AAA. Its rating had been cut. Probably it’s an overreaction. But I think they do well. It’s paying a 10% yield and it may go down in time, but still it’s a lot better than nearly one quarter percent on a treasury bill.
GE rather will be a survivor. Over time, as the economy recovers it’s definitely a company that will come back. You really want to have cash flow and very little debt and that company certainly has both of them.
Andrew Mickey: Do you ever invest in bonds or fixed income with the big yield spreads going on right now?
David Dreman: The high yield bonds are yielding almost 21% annually, but they are anticipating a lot of default. So, during times like these, the best thing to do again is to find a high yield manager with an excellent record. Buy a mutual fund that deals only with high yield bonds and has a very diversified portfolio.
Andrew Mickey: So you are looking a little bit longer term. Are you also looking at the government’s stimulus packages and the government’s role going down the road, if they have a bigger role in regulation and what kind of impact that’s going to have?
David Dreman: I think that the Treasury had no clue of what they were doing. Neither did the Federal Reserve. They reacted very late and they thought the subprime wasn’t serious.
I wrote an article in Forbes and I took their quotes from 2008. They said, “No problem. Subprime will pass in 2007 and in early 2008.” They weren’t the least bit worried.
So they completely dropped the ball. By the time they realized what was going on – around the middle of 2008 - the bond markets froze up. You couldn’t buy or sell high yield bonds.
The markets were gone and the treasury still didn’t react nor did the Federal Reserve. It only came after Bear Stearns and Freddie and Fannie. It was apparent by early 2007 we had a serious problem with the bankers and the Secretary of the Treasury and Bernanke both said this was not serious, they totally missed it.
The complex instruments banks have created are going to take a long time to unwind. Some of them were yielding up to 15% in subprime and whatnot. The rating agencies all gave them AAAs. Then we looked under the hood to see how dangerous they were and it wasn’t pretty.
That’s why the rating agencies have become so stringent now. They were wrong by way too much. And they were far too easy with their ratings three, four and five years ago. Now they are doing it the opposite way and they are destroying really good companies.
So again, this downward spiral is just getting worse. There is a lot of it. You can’t make sure it’s due to one fact because there are just so many factors that are coming.
Andrew Mickey: So do you see at least part of the current downswing, in both the economy and the markets, as a psychological overreaction?
David Dreman: Yes, absolutely. We haven’t seen anything this bad except maybe in 1932 or 1933.
So, you know, nobody has gone without credit. And there is great fear that no bank, no financial stocks should be bought because they have problems.
So I think the psychology is a very big factor here, yes.
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Andrew Mickey: When you started buying manufacturing in the early ‘80s - what was it like back then? When unemployment hit 10%...did everyone think it was all over again - kind of like they do now - even though we are still kind of on the downturn?
A lot of novice individual investors I talk to want to buy anything at all. They don’t even want to get back in a little bit. Is that what it was like back then?
David Dreman: It is, somewhat. Back then many investors were terrified too.
But it shouldn’t matter for value investors. Normally, value investing is a pretty easy job because you tend to buy solid companies that are going to come out of it fine. But what we are seeing now is that even solid companies are being hurt because they can’t raise money. So it’s something different; it’s a very serious panic.
How long until this settles is hard to say. In order for it to end the consumer has to reliquify his home. You see, government policy stressed not having subprime, and other forms of mortgages, and most people bought too much with regards to their houses. As a result, the fall is significant and they continue to fall.
So it’s a more serious problem. But I think we will come out of it. I think that it’s going to take a while because how do we reliquify the consumer? We can take his mortgage away to some extent, which hasn’t been done yet, and we have to find a way of buying the mortgage because the banking system is suspended and money is sitting on it. They have so many bad debts no wonder.
So it’s going to take a while to get through all this but I think we will. We always have and there’s no reason to think that the stock market has changed forever. We came out of a time where there was incredible credit and we went into one of credit absolutely disappearing, and that’s going to take adjustment.
I think in some of the ways - I have probably got a list of things I would do and other people have those too, but until the administration, you know, Secretary of Treasury and the head of the Federal Reserve have a cleaner idea of what to do, I think there is not much that can be done.
Andrew Mickey: Every time something disastrous happens there is always a fall guy, and this time, it’s going to be the hedge funds and the Federal Reserve, in addition to a handful of others.
Everyone is going to take a piece of blame. Do you think the hedge funds are really to blame for the rise in oil prices (See article: Prospects for an Oil Recovery)? Are they facing a real problem or did they just add liquidity?
David Dreman: I think they can be a problem. The previous administration believed in the 19th century thinking where anything goes.
It believed the in Greenspan. I guess one of my all-time heroes (sarcastic). I am not allowed to write about them, but I thought he was very incompetent. But in any case, he believed the economy will bail itself out.
So, is the President, Treasury Secretary and the rest of them thought that they could just let it go and banks would just bounce back.
What they didn’t know, is that there are so many derivatives out there and other types of instruments that just piled up. Now we have to deal with them and that’s going to take a while.
Andrew Mickey: You mentioned something earlier about the psychology of a more educated people in finance or more advance systems. Do you think that comes down to – over the years, they developed consistent overconfidence in the systems or overconfidence in the government bail out of entities or –?
David Dreman: Well, I think right now, they are very frightened. They are very frightened government bail out won’t go through, the banking bail out won’t go either.
It will take time to build confidence and we are not there yet. So I would only buy a portion of what I was going to buy over time, right now.
Is now the time to buy stocks?
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Andrew Mickey: Can you share one mistake that you see most individual investors make or that you use to make a while ago that you have learnt from?
David Dreman: I think probably the most important mistake, and it’s so easy to make here is that, you probably want to have some patience.
You want to buy some stocks, but not everything right now. And you don’t want to over concentrate anything. You want to diversify pretty wisely.
The most important thing is psychological and it’s hard to follow. When markets go against you if you think you have good stocks stay with it. Mostly we’re in and out and then when the market turns. Remember, when the market does turn, maybe about 43% of the upswing comes in the first 15 to 20 days. So you have to have some exposure to stocks to get in on the biggest part of the upturn.
Andrew Mickey: Do you think we are looking at decades, years, or months until we see the first signs of a recovery?
David Dreman: You know, I think that Benjamin Franklin said, “This too shall pass.” And when it comes to the current financial crisis, it too shall pass.
It will. It’s going to be painful but anybody who can hold through this crisis will be well rewarded. I can’t say - nobody can say - whether it’s going to be 6 months, 18 months, or 24 months. But I think they are going to see the value there in many different securities. When it comes to equities, you’ll be in for a double or triple if you have good quality stocks.
Andrew Mickey: Okay. And there is one more question. You mentioned that you are working on a new book, what’s going to be the focus of your new book?
David Dreman: It will be towards the behavioral psychology.
Andrew Mickey: Great, well I certainly look forward to it. Thanks for your time today. A pleasure speaking with you.
David Dreman: You too. Thanks.
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