So which value giant has most influenced your investment thinking? This was a question The Value Perspective put to the distinguished audience at the recent London Value Investor Conference (note how casually we mention our participation in one of the key events of the investment calendar). The four choices we put forward were Ben Graham, Warren Buffett, Howard Marks and David Dreman.
If one of your first thoughts was ‘David Who?’, then you are not alone – Dreman, a Canadian who at 79 is still chairman of the investment company he founded in 1977, won very few votes. Nevertheless, since it is in our contrarian nature to support the underdog – not to mention the fact The Value Perspective is happy to cite Dreman as an influence on our thinking – let’s look at some of his work.
While plenty of people had already written on the theory of why value investing should work, Dreman was one of the first investors to demonstrate, on a statistic basis, why it does work. A good illustration of this can be found in a 1995 article he co-wrote with then colleague Michael Berry for theFinancial Analysts Journal on the subject of earnings surprises and the impact these can have on stocks.
Yes, we acknowledge Overreaction, underreaction, and the low-P/E effect was published 20 years ago and the two decades’ worth of data it uses – from the mid-1970s to the mid-1990s – was an especially good time to have been a value-oriented investor, but we would strongly argue the article’s conclusions still hold true today.
There are, of course, plenty of investors who believe forecasting earnings and earnings surprises is the key to investment success and that is, in theory, perfectly understandable. The practical issue, which regular visitors to The Value Perspective will spot in an instant, is investors have as little chance of successfully and consistently forecasting earnings and earnings surprises as they do anything else.
Now, what Dreman did was to look at the impact – both positive and negative – that earnings surprises can have on stocks, depending on how they are valued. The article focuses on the most expensively-valued stocks – that is, the 20% of the market with the highest price/earnings (P/E) ratios – and the cheapest ones – the 20% of the market with the lowest P/E ratios.
When expensive stocks receive some good news on the earnings front, Dreman found, this tends to be discounted quickly – after all, the stocks are highly valued precisely because the market is expecting great things of them. On the other hand, good news for cheap stocks, which are likely to be ones expected to fare poorly, is viewed as extremely good indeed and the share price tends to do very well.
According to Dreman’s analysis, in the quarter after an earnings announcement offered a positive surprise, the average relative return for the cheap stocks was 20%, compared with 6% relative for the expensive ones. Of arguably greater interest, however, is the way a positive surprise for lowly-valued businesses can have an ‘echo’ over time.
So the cheap stocks not only rose in price in the first quarter after a positive earnings surprise, they also outperformed the market significantly over the second, third and fourth quarters. In contrast, after the expensive stocks enjoyed their one-quarter tick upwards, they tailed off over the next three quarters to the extent they actually gave back everything they received in the wake of the initial surprise.
Dreman also found the inverse to be true for negative earnings surprises. Thus, if a cheap stock that nobody likes sees an earnings downgrade or a profit warning, then yes, it underperforms the market – but not by very much. If an expensive stock that everyone loves is the subject of some bad earnings news, however, then things can get messy.
In this scenario, according to Dreman’s analysis, the average share price cratered by 19% relative in the first quarter – and, once again, there was an echo. Over the second, third and fourth quarters, the expensive stocks continued to do poorly to the extent that, over the one-year holding period, they underperformed the market by 9.5%.
For their part, cheap stocks actually tend to outperform the market because, although they suffer that one-quarter hit, by the time the second, third and fourth quarters roll around, the market has forgotten all about the earnings surprise – assuming it cared that much in the first place. Here on The Value Perspective we often talk about the importance of the ‘margin of safety’ that more lowly-valued businesses can provide investors and this is an excellent illustration of the idea in action.