Investing in Small Caps: Why it Pays to be Contrarian

by Louis Basenese

Investing in Small Caps: Why it Pays to be Contrarian

by Louis Basenese, Advisory Panelist

Tuesday, August 18, 2009: Issue #1069

Editor's Note: Earlier this summer, Louis Basenese gave Oxford Club members another reason why investing in small caps is so profitable. With the markets pulling back, the opportunities for small-cap stocks are opening up again. We felt it was time for another look at small caps and one of the masters of contrarian investing, David Dreman.

Having a contrarian view of the markets can be wildly profitable.

In the last two years, I've:

  • Gone long the dollar when it was in the tank...

  • Shorted oil near its peak...

  • Shorted the big move to Treasuries on the heels of the credit crisis...

  • And, most recently, shorted gold at $918 an ounce.

At the time of recommendation, each trade was extraordinarily unpopular, prompting some folks to flat out question my sanity. And yet, taking the dissenting opinion made money each time (the jury's still out on the shorting gold trade.)

How'd I find the wherewithal - and nerve - to do it?

David Dreman - The Father of Contrarian Investing

I've been under the tutelage of David Dreman, known as "The Father of Contrarian Investing," for many years.

Dreman literally wrote the book on contrarian investing. (If you don't own a copy of his latest work - "Contrarian Investment Strategies: The Next Generation" - get one!)

In the book, he lays out his straightforward, time-tested investment philosophy to consistently outperform the markets: choose cheap investments that other investors hate.

Sounds too simple to be true, I know. But like any trading genius, Dreman's track record underpins his investment philosophy...

  • Since inception in 1988, his flagship large-cap value fund's average annual return of 9.2% beats both the S&P 500 and Russell 1000 Value index by a full percentage point. His small-cap value fund has performed even better.

  • Since inception in 2003, it has trounced the Russell 2000 Index (the benchmark for small-cap investments) and the S&P 500 index by more than seven percentage points.

Investing in Small Caps Predictions Ring True...

Recall, in January I predicted small cap investing would shine this year because they always do coming out of recessions. And this time has been no exception.

  • From the March 9 bottom, small-cap stocks are up 50%, compared to 40% for large-caps stocks.

  • And using history as our guide, we can expect more of the same ahead - small caps to trump the gains of their larger-cap peers for at least three more years.

  • Thus, not capitalizing on this disparity would be foolish.

  • Furthermore, the recent rally has increased stock valuations virtually across the board, so finding winning stocks will require increasingly more investment skill.

And that's where Dreman comes in... No one on earth is better at unearthing small-cap value investments than he has been.

So how does he do it?

  • First, he exploits the fact that the U.S. stocks with the lowest 20% of price-to-earnings ratios returned 16.8% per year from 1920 to 2004 - four percentage points better than the market as a whole. He buys nothing but such undervalued stocks.

  • That said, he doesn't just focus on the "cheapness" of a stock to determine its worthiness. "We don't like dogs," says Dreman, adding that, "All our stocks are financially strong, have high yields and earnings growth faster than the market."

  • He pays great attention to the stock filtering process, as well. Specifically, Dreman looks for companies with market caps between $300 million and $2.5 billion. Those are then screened based on their respective P/Es.

  • Stocks with P/E ratios greater than the market get discarded, immediately (Dreman is innately opposed to paying a premium for growth). And the remaining companies (those with P/E ratios below the industry median) must possess an above average dividend yield, low leverage, low price-to-book and price-to-cash flow ratios, strong management teams and a catalyst that could spur future growth.

The result is typically three to four stocks in each industry group, with only one or two making the final cut.

Collectively, Dreman uses this investment process to construct a portfolio of 95 to 100 stocks from 50 different industry groups, with a 1% weighting to each. Such a small position size means that a single security can't sour the overall portfolio performance. Which adds another layer of downside protection. (Deep-value stocks are inherently less risky than high-flying, high P/E growth stocks, anyway).

So clearly, Dreman does much more than simply buy small cap companies that investors have discarded, or ones in the midst of tough times. As he puts it, "We look for reasonably strong companies on the whole."

But to really put his words into perspective, let's consider a recent purchase...

Dreman Invests In Small-Caps With Aaron's Inc.

Last year, Dreman added Aaron's Inc. (NYSE: AAN) - a small-cap company that allows consumers to rent-to-own plasma TVs, household and office furniture and computers, without any credit checks.

Most investors looked at that business model, cringed and sold the company's stock, causing it to lose 33% in 2007. After all, could you get any riskier than catering to consumers with poor or no credit during a credit crunch?

Dreman, of course, is too smart to fall for that. This guy can sniff out his prey from a mile away. He knew the current credit freeze was about to push previously credit-worthy buyers away from Best Buy and right through Aaron's front doors. And with the stock trading at a historically low valuation below 11 times earnings, it was a no-brainer.

Sure enough, with an uptick in demand, Aaron's earnings jumped a solid 19% last year alone.

And the stock defied the market, rallying 39% in 2008 while everything else took a bath. This year, it's tacked on another 25%, thanks to a 55% jump in earnings in the first quarter.

Bottom line, small cap stocks can be some of the most profitable investments in any market. Should this market pull-back continue, consider this another great opportunity to pick up some attractive small caps.

But like Dreman, I recommend you stay away from dogs at any price.

Good investing,

Louis Basenese

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