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WALL STREET, CALIFORNIA | MANAGER'S FORUM

Value Judgments : How a Master Spots Good Buys Among Low P/E Stocks

November 05, 1996

David Dreman is considered one of the masters of "value" investing, the stock discipline that focuses on issues selling for below-average price-to-earnings ratios and above-average dividend yields. His Dreman Value Advisors, which he founded in 1976, now manages $2.8 billion, including $520 million in the Kemper-Dreman High Return stock fund.

The fund has gained 20.8% this year, and its 135.2% return over the last five years ranks it first in its category, according to Lipper Analytical Services. Dreman, 60, divides his time between New York and Aspen, Colo. He spoke with Times staff writer Tom Petruno.

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Times: How did you come to be a value player, as opposed to someone who chases hot growth stocks?

Dreman: I guess I always was a value player, but I had a leave of absence from it in 1968, the time of the "go-go" growth stocks. People I worked with had portfolios that went from a few thousand dollars to $300,000 [in a matter of months]. But then I saw them lose it all by 1970. There's nothing like that to make you a believer in value.

Times: "Value" means different things to different people. How do you judge value in a stock?

Dreman: There are a number of ways. Judging by price-to-book-value works [stock price relative to the per-share value of a company's assets]. But for the High Return fund, a low price-to-earnings ratio [P/E] is our primary criterion.

Studies on value investing show that the stocks selling for the bottom 10% to 20% of P/Es outperform the market over time. So today, if the market is at an average P/E of 17 on trailing 12-month earnings, the bottom 20% of P/Es would be in the 13 to 14 area. That would be our focus.

Times: So you're basically trying to own "cheap" stocks relative to the market. It seems logical enough. How come everybody doesn't do it?

Dreman: In theory it's the easiest investing strategy. In practice it's one of the hardest.

Times: Because cheap stocks are generally unloved stocks?

Dreman: Yes. People don't realize how powerful psychology is in decision making. Try holding bank stocks in a period like 1990 [during the banking crisis]. We did. Everyone on Wall Street was bearish on the stocks. In a time like that it's very difficult to know you're right. . . . Forces like these tend to push people away from value stocks.

Times: Yet the theory is that value stocks beat the market as a whole over time?

Dreman: Yes. Value investing has worked over the past 65 years, but not every quarter of every year. If you adhere to it, you'll be behind the market sometimes.

Times: In fact, the High Return fund lost about 9% in 1990, which was worse than the market overall.

Dreman: And people said to us in 1990, "You did something wrong; you've changed."

Times: Right, well, your five-year performance speaks for itself. But if value investing works over time, exactly why does it work?

Dreman: Because people are too sure of themselves in their sense of accurately forecasting the future for today's "best" and "worst" stocks. So surprises play a big role.

People don't expect negative earnings surprises from a high P/E stock, and they don't expect positive surprises from a low P/E stock. So high P/E stocks get killed when they disappoint. And when low P/E stocks have a positive surprise, people don't expect them, so the stocks really blast off.

Times: But you're not just talking about buying any out-of-favor, low P/E stock, are you?

Dreman: No, what we're looking for are low P/E stocks whose earnings are rising at an above-market rate.

Times: And what about a sell discipline? How do you know when it's time to let a stock go?

Dreman: First, we have an automatic sell discipline on the P/E: If a stock's P/E hits the market average, we sell it, because it's no longer a low P/E stock, obviously.

We also have a three-year rule: If a stock isn't working out after three years, we let it go.

Finally, if the fundamentals of a company are deteriorating on us, we sell. But the fundamentals don't often change for our companies. Our turnover is very low.

Times: Let's talk about your big holdings. You've got the two government-chartered mortgage finance firms: Federal National Mortgage, or Fannie Mae, is No. 1, and Federal Home Loan Mortgage, or Freddie Mac, is No. 4.

Dreman: These are just great companies. They've grown 20%-odd annually over the last 15 years.

Times: But the P/Es are still relatively low--about 15 times 1996 estimates for both.

Dreman: Yes. I think if we didn't have the Internet [and the hype over Net stocks], Fannie and Freddie would be at 40 times earnings.

Times: You also still own a lot of the banks.

Dreman: We've got NationsBank, First Union, Banc One, Bank of New York and KeyCorp, among others. The whole portfolio of them is still pretty cheap: P/Es of about 11 or 12, price-to-book values about half the market average, and dividend yields that are 40% or 50% more than the market.

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