Based on David Dreman, Contrarian Investment Strategies: The Psychological Edge (1998, revised editions)
David Dreman (1936-2023) was one of the most successful and influential contrarian investors of the modern era. As founder and chairman of Dreman Value Management, he managed billions of dollars using a disciplined contrarian approach that consistently outperformed the market over decades. His book Contrarian Investment Strategies is the definitive work on why unpopular stocks outperform popular ones, grounded in both empirical evidence and behavioral psychology.
The market systematically overvalues popular stocks and undervalues unpopular ones. This overreaction is driven by well-documented psychological biases — overconfidence, anchoring, herd behavior, and the affect heuristic — that cause investors to extrapolate recent trends too far into the future. By buying the stocks that the market has punished most severely (low P/E, low P/B, low P/S, high dividend yield) and avoiding those it has rewarded most generously (high P/E, high P/B, high P/S), investors can earn significantly above-average returns over time.
Dreman's work is distinguished by its rigorous empirical foundation. He does not merely assert that contrarian strategies work — he presents decades of data across multiple metrics, time periods, market conditions, and national markets. The evidence is overwhelming and consistent:
HISTORICAL PERFORMANCE SUMMARY (approximate, from Dreman's research):
Strategy Annual Return vs. Market Average
Lowest 20% P/E stocks ~16-18% +3-5% above market
Lowest 20% P/B stocks ~16-17% +3-4% above market
Lowest 20% P/S stocks ~16-18% +3-5% above market
Highest dividend yield ~15-17% +2-4% above market
Highest 20% P/E stocks ~10-12% -1-3% below market
Highest 20% P/B stocks ~10-11% -2-3% below market
Highest 20% P/S stocks ~9-11% -2-4% below market
Lowest dividend yield ~10-12% -1-3% below market
Market average ~13%
Period: 1970s through 1990s (multiple studies)
Note: Exact figures vary by study period and methodology.
The PATTERN is consistent across all periods studied.
If contrarian strategies work so well, why doesn't everyone use them? Dreman identifies several reasons:
Dreman builds on the work of psychologists Daniel Kahneman and Amos Tversky to explain why markets overreact. The key biases:
Representativeness Bias: Investors judge the probability of future outcomes based on how closely current conditions resemble a familiar pattern, rather than on base-rate probabilities. A company that has grown earnings for five straight years "looks like" a growth company, so investors assume it will continue growing — often paying 40-50x earnings for this extrapolation.
Anchoring: Investors anchor to recent trends and adjust insufficiently. If a stock has been rising for two years, investors anchor to the uptrend and assume it will continue. If a stock has been falling, they anchor to the downtrend.
Availability Bias: Recent, vivid, and emotionally charged events are weighted too heavily in decision-making. A company that just reported terrible earnings is judged more harshly than the objective situation warrants because the negative news is highly available in investors' minds.
Herd Behavior: Investors follow the crowd because disagreeing with consensus is psychologically costly. Buying a popular stock that then falls is "bad luck." Buying an unpopular stock that falls is "bad judgment." The social penalty for independent thinking drives conformity.
THE OVERREACTION CYCLE:
FOR POPULAR STOCKS (Overvaluation):
1. Company has strong recent performance
2. Analysts raise estimates and price targets
3. Media coverage becomes positive and frequent
4. Investors extrapolate recent success far into the future
5. Stock price rises to unsustainable P/E (30x, 40x, 50x+)
6. Even a small disappointment triggers a massive decline
7. The stock was a "great company" at 50x; now it's "damaged goods" at 15x
FOR UNPOPULAR STOCKS (Undervaluation):
1. Company has weak recent performance or a crisis
2. Analysts cut estimates and price targets
3. Media coverage becomes negative (or absent)
4. Investors extrapolate recent problems far into the future
5. Stock price falls to abnormally low P/E (5x, 8x, 10x)
6. Even a small positive surprise triggers a significant rally
7. The stock was "hopeless" at 5x; now it's "recovering" at 12x
THE CONTRARIAN OPPORTUNITY:
Buy in Step 5-6 of the unpopular cycle
Sell in Step 5-6 of the popular cycle
Dreman argues that overreaction is not a temporary market anomaly that will be arbitraged away. It persists because it is rooted in human psychology, which does not change. The same biases that caused overreaction in the 1930s cause it today and will cause it in 2050. Markets evolve, but human nature does not.
Dreman's most extensive research focuses on the price-to-earnings ratio. He divides the market into quintiles (five groups of 20% each) based on P/E and tracks returns over extended periods:
P/E QUINTILE PERFORMANCE (illustrative, based on Dreman's research):
Quintile P/E Range Annual Return Cumulative (20 years)
Lowest 20% 5-10x ~17% $100 → ~$2,300
2nd quintile 10-14x ~15% $100 → ~$1,600
3rd quintile 14-18x ~13% $100 → ~$1,150
4th quintile 18-25x ~12% $100 → ~$960
Highest 20% 25x+ ~11% $100 → ~$810
The lowest P/E quintile CONSISTENTLY outperforms across:
- Bull markets and bear markets
- Inflationary and deflationary periods
- Different decades (1970s, 1980s, 1990s)
- US and international markets
Price-to-book value shows a similar pattern. Stocks trading at the lowest price-to-book ratios outperform those trading at the highest. Dreman notes that P/B is particularly useful for financial companies and asset-heavy industries where book value is a meaningful measure.
Price-to-sales may be the most robust contrarian indicator because sales figures are harder to manipulate than earnings and book value. Companies can manage earnings through accounting choices and write down book value through restructuring charges, but sales are relatively straightforward.
High-dividend-yield stocks consistently outperform low-dividend-yield stocks. This effect is partly explained by the value tilt (high-yield stocks tend to have low P/Es) and partly by the behavioral tendency to undervalue the power of reinvested dividends.
Dreman tested which single metric is the most reliable contrarian indicator and found that low P/E is the strongest standalone predictor. However, using multiple contrarian indicators together provides even better results:
CONTRARIAN INDICATOR STRENGTH (ranked):
1. Low P/E (strongest individual predictor)
2. Low P/S (most robust to accounting manipulation)
3. Low P/B (best for asset-heavy industries)
4. High Dividend Yield (works best with reinvestment)
5. Low P/CF (price-to-cash-flow) (eliminates accounting distortions)
COMBINATION STRATEGY:
Buy stocks that rank in the lowest quintile on TWO OR MORE
of these metrics simultaneously → even higher outperformance
One of Dreman's most important contributions is his documentation of the systematic nature of analyst forecast errors. Analysts do not make random errors — they make predictable, directional errors:
ANALYST FORECAST ERROR PATTERNS:
For POPULAR (high P/E) stocks:
- Analysts are systematically TOO OPTIMISTIC
- Consensus earnings estimates are too high
- When the company reports actual earnings below estimates,
the stock drops sharply ("earnings surprise")
- Average negative surprise frequency: ~45% of quarters
- Average magnitude of negative surprise: -5 to -15%
For UNPOPULAR (low P/E) stocks:
- Analysts are systematically TOO PESSIMISTIC
- Consensus earnings estimates are too low
- When the company reports actual earnings above estimates,
the stock rises sharply ("positive surprise")
- Average positive surprise frequency: ~50% of quarters
- Average magnitude of positive surprise: +5 to +15%
THE ASYMMETRY:
High P/E stocks: Priced for perfection → more downside surprises
Low P/E stocks: Priced for disaster → more upside surprises
This asymmetry is THE primary driver of the contrarian advantage.
Dreman identifies several sources of systematic analyst error:
Dreman uses earnings surprises as a key mechanism for contrarian revaluation:
DOUBLE WHAMMY EFFECT:
Year 0: Company earns $2/share, trades at 8x P/E = $16/share
Year 2: Company earns $2.50/share (25% earnings growth)
Market reassesses: P/E expands from 8x to 14x
Stock price: $2.50 × 14 = $35
Return: ($35 - $16) / $16 = 119%
Decomposition:
From earnings growth: 25%
From P/E expansion: 75%
From both combined: 119%
The P/E expansion is the key — it represents the market correcting
its prior overreaction to negative sentiment.
Dreman identifies the events that typically trigger revaluation of undervalued stocks:
Positive Earnings Surprise: The most common trigger. When a stock priced for disaster reports decent or good earnings, the pessimistic consensus is challenged and the stock re-rates.
Management Change: New management — especially a CEO known for operational excellence or turnaround expertise — can change the market's perception overnight.
Activist Investor: When a prominent activist investor takes a significant stake and pushes for changes (cost cuts, divestitures, share buybacks, strategic shifts), the market often re-rates the stock in anticipation of improvements.
Industry Tailwind: A secular shift that benefits the entire industry — regulatory change, demand growth, commodity price shift — can lift all stocks in the sector, including the cheapest ones.
Share Buybacks: When a low P/E company uses its cash flow to buy back shares, it reduces the share count, increases earnings per share, and signals management confidence.
Dividend Increase: A dividend increase or initiation signals management's confidence in future cash flows and attracts income-seeking investors.
Dreman's research shows that contrarian revaluation typically occurs over 1-5 years. Some stocks re-rate within months of a positive catalyst; others take several years. The investor must be patient enough to hold through the waiting period but also realistic that not every cheap stock will recover.
Dreman provides specific, implementable rules for building a contrarian portfolio:
DREMAN'S CONTRARIAN SELECTION CRITERIA:
RULE 1: LOW VALUATION (at least one, preferably multiple)
□ P/E in the lowest 40% of the market (or below 12x)
□ P/B in the lowest 40% of the market (or below 1.5x)
□ P/S in the lowest 40% of the market (or below 1.0x)
□ Dividend yield in the highest 40% of the market (or above 3%)
RULE 2: FINANCIAL STRENGTH
□ Current ratio > 1.5 (adequate short-term liquidity)
□ Debt-to-equity < 0.60 (manageable leverage)
□ Interest coverage > 5x (can comfortably service debt)
□ No recent earnings losses (at least 3 of last 5 years profitable)
RULE 3: EARNINGS QUALITY
□ Positive operating cash flow
□ Earnings are not primarily from one-time items
□ Revenue is growing or at least stable (not in secular decline)
□ Margins are stable or improving (not in free fall)
RULE 4: MINIMUM SIZE
□ Market capitalization > $1 billion (avoid micro-cap traps)
□ Adequate daily trading volume (can enter and exit without
significant market impact)
RULE 5: DIVIDEND SAFETY (for dividend-focused strategy)
□ Dividend payout ratio < 75% (sustainable payout)
□ Dividend has not been cut in the last 5 years (stability)
□ Free cash flow covers dividend by at least 1.5x
Dreman is equally specific about what contrarian investors should avoid:
CONTRARIAN TRAPS TO AVOID:
1. VALUE TRAPS — stocks that are cheap for good reason:
□ Secular decline in the industry (e.g., print newspapers)
□ Technological obsolescence
□ Unmanageable debt burden
□ Persistent revenue decline (>3 years)
□ Negative free cash flow with no clear path to positive
2. ACCOUNTING RED FLAGS:
□ Frequent restatements
□ Revenue recognition changes
□ Growing gap between earnings and cash flow
□ Excessive use of "adjusted" or "non-GAAP" earnings
□ Auditor changes
3. GOVERNANCE RISKS:
□ Dual-class share structures favoring insiders
□ Excessive management compensation
□ Related-party transactions
□ Empire-building acquisitions
□ Insider selling during stock declines
Dreman emphasizes that the best contrarian investments are good companies with bad stocks — companies that are fundamentally sound but temporarily out of favor due to an earnings miss, a sector rotation, a macroeconomic scare, or some other reversible factor. The distinction between "bad stock" (temporarily cheap due to market overreaction) and "bad company" (fundamentally impaired) is the most important judgment a contrarian investor makes.
Unlike focus investors who own 8-15 stocks, Dreman recommends broader diversification for contrarian portfolios — typically 20-30 stocks. This is because individual contrarian picks carry higher idiosyncratic risk (any individual cheap stock may be a value trap), and diversification ensures that the statistical advantage of the strategy manifests reliably.
CONTRARIAN PORTFOLIO STRUCTURE:
Position count: 20-30 stocks
Maximum position size: 5% at cost
Maximum sector weight: 25%
Minimum sector count: 5 different sectors
Rebalancing:
Annual review — replace stocks that have re-rated
(P/E has risen to market average or above)
with new contrarian candidates (stocks that have become cheap)
Expected turnover: 20-40% annually
(Low by active management standards, but higher than focus investing)
Dreman shows that the contrarian advantage increases with time. Over any single year, a contrarian portfolio might underperform. Over 5 years, underperformance becomes rare. Over 10 years, contrarian strategies almost always outperform.
PROBABILITY OF CONTRARIAN OUTPERFORMANCE:
1-year rolling periods: ~55-60% outperform
3-year rolling periods: ~65-75% outperform
5-year rolling periods: ~75-85% outperform
10-year rolling periods: ~85-95% outperform
20-year rolling periods: ~95%+ outperform
Implication: The contrarian strategy works, but you must give it TIME.
Short-term underperformance is not evidence that the strategy has failed.
Dreman demonstrates that low P/E stocks actually have LESS downside in bear markets than high P/E stocks. This seems counterintuitive (cheap stocks should be riskier), but it makes sense: cheap stocks are already priced for bad news. There is less room to fall. Expensive stocks priced for perfection have much further to fall when reality disappoints.
BEAR MARKET BEHAVIOR:
High P/E stocks (top quintile):
Average bear market decline: -30 to -45%
Multiple compression + earnings disappointment = double whammy down
Low P/E stocks (bottom quintile):
Average bear market decline: -15 to -25%
Already low expectations = less room for disappointment
The contrarian portfolio provides a NATURAL cushion in bear markets
without requiring any market timing or hedging.
Dreman does NOT use mechanical stop-losses. He argues that stop-losses are antithetical to contrarian investing: a stock that drops further below its already-low valuation is potentially an even better buy, not a sell signal. Instead, he uses fundamental deterioration as the sell trigger.
Different sectors rotate in and out of favor, creating contrarian opportunities at the sector level. Dreman identifies patterns:
SECTOR ROTATION AND CONTRARIAN OPPORTUNITIES:
CYCLICAL SECTORS (Energy, Materials, Industrials):
Contrarian buy: During recessions when earnings are depressed
and P/Es appear high (on cyclically low earnings)
Contrarian sell: During expansions when earnings are elevated
and P/Es appear low (on cyclically high earnings)
NOTE: Use normalized (mid-cycle) earnings for P/E calculations
DEFENSIVE SECTORS (Utilities, Consumer Staples, Healthcare):
Contrarian buy: During bull market euphoria when investors
chase growth and neglect defensives
Contrarian sell: During bear markets when investors flee to
safety and bid up defensive stocks
GROWTH SECTORS (Technology, Biotech):
Contrarian buy: After a sector-wide crash that punishes
good and bad companies indiscriminately
Contrarian sell: When the sector's P/E exceeds 2x the market average
FINANCIAL SECTORS (Banks, Insurance):
Contrarian buy: During credit crises when market assumes
widespread insolvency (usually overestimated)
Contrarian sell: When loan growth accelerates and credit
standards loosen (signs of a coming downturn)
Dreman warns against buying cheap stocks in industries in permanent decline. The contrarian edge comes from buying stocks that are temporarily out of favor, not permanently impaired. Key distinctions:
| Situation | Action |
|---|---|
| Cyclical downturn in a healthy industry | BUY — classic contrarian setup |
| Temporary company-specific problem | BUY — if fundamentals support recovery |
| Secular decline in the industry | AVOID — cheap will get cheaper |
| Technological disruption | AVOID — unless company is the disruptor |
| Regulatory destruction of profitability | AVOID — permanent impairment |
Dreman notes that contrarian strategies work internationally as well as domestically. Country-level overreaction creates opportunities: when a country's market crashes due to a crisis (Asian financial crisis, European debt crisis), the stocks of fundamentally sound companies in that market often become deeply undervalued.
Dreman does not practice precise market timing but does adjust portfolio aggression based on broad market valuation:
MARKET VALUATION AND PORTFOLIO STANCE:
Market P/E < 12 (historically cheap):
Stance: AGGRESSIVELY BULLISH
Action: Fully invested in contrarian stocks
Cash: 0-5%
Market P/E 12-18 (fair value zone):
Stance: MODERATELY BULLISH
Action: Fully invested, normal contrarian selection
Cash: 5-10%
Market P/E 18-25 (expensive):
Stance: CAUTIOUS
Action: Only buy extreme contrarian bargains
Cash: 10-20%
Begin raising quality standards
Market P/E > 25 (historically expensive):
Stance: DEFENSIVE
Action: Hold existing positions; do not add
Cash: 20-30%
Prepare shopping list for the correction
Dreman identifies several contrarian signals at the market level:
Extreme Pessimism (Buy Signal):
Extreme Optimism (Caution Signal):
Dreman frames contrarian investing as the systematic exploitation of predictable psychological biases. The biases are not random — they are consistent, directional, and measurable. This makes them exploitable:
BIAS → MARKET ERROR → CONTRARIAN STRATEGY
Recency bias → Extrapolate recent trends forever
→ Buy stocks with bad recent trends (mean reversion)
Overconfidence → Believe forecasts are more accurate than they are
→ Bet against extreme consensus forecasts
Loss aversion → Feel losses 2x more than equivalent gains
→ Buy stocks others have sold in panic
Herd behavior → Follow the crowd into popular stocks
→ Buy the most unpopular stocks
Anchoring → Anchor to recent prices or trends
→ Evaluate stocks on normalized fundamentals, not recent results
Availability bias → Overweight vivid recent events
→ Look past the headline to the underlying business quality
Dreman is honest about the emotional difficulty of contrarian investing:
The intellectual understanding that these feelings are the source of the contrarian advantage does not eliminate them. It only makes them manageable.
Contrarian investors face social pressure that momentum investors do not. If you buy a popular stock and it falls, people sympathize ("everyone lost money in that stock"). If you buy an unpopular stock and it falls, people criticize ("why did you buy that garbage?"). This social penalty reinforces herd behavior and creates the persistent underpricing of unpopular stocks.
STEP 1: SCREEN THE UNIVERSE
Start with all stocks in the S&P 500 or equivalent large-cap index
Rank by P/E, P/B, P/S, and dividend yield
Identify stocks in the bottom 20-30% on at least one metric
STEP 2: APPLY FINANCIAL QUALITY FILTERS
Eliminate stocks that fail the financial strength tests
(debt, cash flow, profitability, liquidity)
This removes most value traps
STEP 3: ASSESS FUNDAMENTAL OUTLOOK
For remaining candidates, evaluate:
- Is the industry in secular decline?
- Is the company's competitive position eroding permanently?
- Is the problem temporary (cyclical, one-time, sentiment) or permanent?
STEP 4: RANK AND SELECT
Rank surviving candidates by overall contrarian attractiveness
(combination of valuation cheapness, financial quality, and
perceived catalyst for revaluation)
Select top 20-30 stocks
STEP 5: POSITION SIZE
Equal-weight (approximately) across all positions
No position above 5% at cost
Maximum 25% in any single sector
STEP 6: MONITOR AND REBALANCE
Review quarterly — check for fundamental deterioration
Rebalance annually — sell stocks that have re-rated,
replace with newly cheap candidates
Expected annual turnover: 20-40%
Dreman's sell rules:
SELL WHEN:
1. REVALUATION COMPLETE
Stock's P/E has risen to the market average or above
→ The contrarian thesis has played out; take profits
2. FUNDAMENTAL DETERIORATION
The company's financial quality has deteriorated materially
(debt up, cash flow down, revenue in persistent decline)
→ The stock is no longer just unpopular — it's genuinely impaired
3. BETTER OPPORTUNITY
A significantly more attractive contrarian candidate exists
and you need capital to fund it
4. HOLDING PERIOD EXCEEDED
If a stock has not re-rated within 3-5 years, reassess
whether the contrarian thesis is valid or if it's a value trap
DO NOT SELL BECAUSE:
- The stock went down further (may be an even better buy)
- An analyst downgraded it (analysts are the source of overreaction)
- The market is in a bear phase (contrarian stocks hold up better)
- You are "bored" with the position (boredom is not an investment thesis)
Contrarian portfolios have a natural tax advantage: because many positions are held for several years before revaluation, gains are long-term capital gains (taxed at lower rates). The 20-40% annual turnover is lower than the 80-100% typical of most active managers.
"The most important investment lesson you can learn is that investors consistently overreact to events, both positive and negative, and that this overreaction creates the most reliable profit opportunity in the stock market."
"Buy stocks that are out of favor and sell stocks that are in favor. This is the single most reliable strategy for above-average long-term returns."
"Analysts' forecasts are as likely to be wrong as the weather forecast. The difference is that nobody buys stocks based on the weather forecast."
"The greatest irony of the stock market is that the stocks investors are most afraid of are the ones they should be buying, and the stocks they are most excited about are the ones they should be avoiding."
"A stock that has already fallen 80% can fall another 80%. But the combination of low valuation AND fundamental quality creates a floor that the purely speculative stock does not have."
"Low P/E stocks outperform high P/E stocks not because cheap stocks are inherently better, but because investor psychology systematically misprices both categories."
"The market's greatest errors come not from stupidity but from the consistent application of cognitive biases to the interpretation of new information."
"Diversification is essential in contrarian investing — not because the strategy is risky, but because individual contrarian picks are uncertain. The strategy works statistically, not stock by stock."
"The emotional difficulty of buying what everyone else is selling is the reason the contrarian premium exists. If it were easy, everyone would do it, and the premium would disappear."
"Earnings surprises are the mechanism by which cheap stocks become fairly valued stocks. The surprise forces investors to revise their overly pessimistic assumptions."
"You don't need to predict the future to be a successful contrarian investor. You only need to recognize that the market's prediction of the future is systematically biased."
"The single greatest advantage a contrarian investor has is time. Over short periods, the market's biases may persist. Over long periods, they always correct."
Contrarian Investment Strategies provides the empirical, psychological, and practical foundation for one of the most robust investment approaches ever documented. Dreman's contribution is not merely identifying that cheap stocks outperform — others noted this before him — but explaining WHY through behavioral psychology, HOW through specific selection criteria, and HOW MUCH through decades of rigorous backtesting. For the investor willing to endure the social and emotional discomfort of buying what others reject, Dreman's framework offers a well-documented path to above-average returns.