David Dreman's Dream Team

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

David Dreman outlined his investment principles in his 1998 book Contrarian Investment Strategies. The gist of Dreman's investment style is that he looks for companies that exhibit the following five traits:

  1. A strong financial position - enables a company to sail unimpaired through periods of operating difficulties
  2. As many favorable operating and financial ratios as possible - ensures there are no structural flaws in the company
  3. A higher rate of earnings growth than the S&P 500 in the immediate past, and the likelihood that it will not plummet in the near future - do not predict precise earnings, merely their direction
  4. Earnings estimates should always lean to the conservative side - if earnings look like they will grow faster than the S&P 500 for a year or so, you have a promising investment
  5. An above-average dividend yield, which the company can sustain and increase

Keep in mind that Dreman is a big believer in diversification. His fund regularly owns well over 100 stocks in each of its portfolios. Dreman truly is a "contrarian" investor; he relies more on traditional measures of valuation (P/E, P/B, etc) than on determining a company's intrinsic value. This is an important distinction to understand when evaluating his portfolio.

Here are a few companies that fit Dreman's principles:

Apple 

Shares of Apple (NASDAQ: AAPL) have retreated to $537 after hitting a 52-week high of $705 just a few months ago. Apple has plenty of cheerleaders, including well-known hedge funders David Einhorn and Daniel Loeb. More importantly, it trades at just 12x earnings (13x free cash flow) despite a fortress balance sheet and enormous earnings potential.

The market seems to be concerned about Apple's recent struggles, which leads me to another point Dreman makes in his book: investors focus too much on the last data point. It's easy to get caught up in the panic and believe that this quarter's results relative to the year ago quarter's results represent a trend, but you have to keep the big picture in mind. It's hard not to believe that Apple will outperform the S&P 500 over the next half-decade when you consider that the market is not pricing in any earnings growth. The market is saying that Apple has peaked and will not continue to bring innovative products to market. All an investor has to do is decide whether or not you believe that to be the case.

Cisco Systems

Cisco's (NASDAQ: CSCO) Q1 results were met with a sharp uptick in the stock price as a result of higher-than-expected revenue and earnings growth. At just over 10x trailing free cash flow, the shares appear to still be underpriced. Like its peers, Cisco has a large cash position with little debt. The company has grown sales at an average of 9.2% per annum over the last 7 years, though EPS growth averaged a somewhat lower 7.7% over the same period. In addition, the company initiated a dividend in the past year. Investors who believe that Cisco can successfully transform into a comprehensive IT solutions company may want to take a closer look at this stock.

UnitedHealth Group

There has been a surprising sell-off in UnitedHealth's (NYSE: UNH) shares since the Nov. 6 election; it was trading around $55 before the election and has since slid to $51.50. According to government figures, an additional 30 million customers will be forced to purchase health insurance over the next half-decade as a result of the implementation of Obamacare. The market has struggled to weigh the competing benefits and drawbacks of Obamacare for health insurers, but the net effect on such a well-connected company as UnitedHealth has to be positive. Where there's government regulation, there's money and influence creating the regulation. Those with money and influence (i.e., large health insurers) will ultimately write the rules to provide a favorable outcome for themselves. It doesn't hurt the investment case that UNH trades at 10x earnings and is expected to grow EPS faster than the S&P 500. Investors who believe that health insurers will ultimately benefit from health care reform should investigate UnitedHealth further.

Suncor Energy

Suncor (NYSE: SU) is another stock that had been on a run until the recent market sell-off; it hit a low of $25.95 per share in early June before making its way back up to $35 and finally settling at around $32 today. The company recently had to write down some assets in Libya related to the disruptions in the country, but it continues to grow its oil sands production at a high-single-digit rate. Investors who are bullish on Canadian oil sands production will be interested in taking a closer look at Suncor.

Medtronic

Medtronic (NYSE: MDT) is a medical devices maker that currently trades at a severe discount to its peers. The company is a classic contrarian play because there are so many overhangs that keep investors up at night. Some fear that Obamacare will hurt medical device makers, while others have questioned the legitimacy of a recent acquisition of a Chinese company (John Hempton believes the Chinese company was fudging its numbers). But from a pure ratio standpoint, MDT looks like a good bet: 12.5x earnings, 7-year average 11.7% diluted EPS growth, and a manageable amount of debt. Medtronic may be worth a look for contrarian investors looking to add a hated stock to a diversified portfolio.

Conclusion

Investors tend to make investment decisions more complicated than they need to be. Making good investments often comes down to finding companies that are cheap based on historical operating performance and determining whether it is reasonable to expect those companies to continue operating in a similar manner in the future. David Dreman's framework for investing is a good way to boil down investments to the important key points so that decision making is simplified.


titans8904 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and Medtronic. Motley Fool newsletter services recommend Apple and UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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