David Dreman's Eclectic Strategy For a Challenging Stock Market
By IAN MCDONALD
THE WALL STREET JOURNAL ONLINE
The S&P 500 is underwater over the past three years and trailing the average bond fund over the past five, but stock-picker David Dreman isn't fazed.
That's because the amiable Canadian who came to check out the US markets for a year in his 20s -- and has stayed for more than 35 years --thrives on the panic of others. A pioneer of the contrarian investment style, he spends his days picking through Wall Street's dumpster looking for troubled companies most wouldn't touch while wearing rubber gloves. The idea: Buying an battered castaway can pay off for those willing to ride out the current storm.
The approach leads to an eclectic portfolio with big bets on financial stocks like mortgage titans Freddie Mac and Fannie Mae, alongside tobacco picks like Philip Morris and UST Inc. More than a quarter of the $4.7 billion Scudder Dreman High Return Equity fund's money was invested in these four stocks at the end of the first quarter.
Mr. Dreman's bold, tightwad style has led to a 15% annualized gain over the past decade, which tops the S&P 500 and nearly all of the fund's peers according to New York-based fund tracker Lipper. Of course, the fund's deep value approach can backfire in a growth rally, as it did in the late 1990s.
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Today Mr. Dreman's yen for beaten-down companies is leading him to embattled conglomerate Tyco International, which he bought in the first quarter when the company faced rising concerns about accounting practices and business strategy. That bet has become more intriguing now that Chief Executive L. Dennis Kozlowski's has resigned and faces an indictment on charges of tax evasion. Mr. Dreman has also started buying ravaged energy traders that have buckled in the wake of Enron's collapse.
Is he looking at cratered tech stocks and are stocks cheap or expensive after more than two years of declines? We got some answers.
1. Some value investors have said it's getting tough to find bargains these days. Given your contrarian style, where are you investing now?
I think there's a lot of value out there today. The S&P 500 is floundering and trading at more than 20 times earnings and that's probably based on a lot of pro forma earnings estimates are inflated. But there are companies we like, like Freddie Mac and Fannie Mae, that have good, predictable earnings growth. Those two companies are growing [their earnings] at 15% and trading at under 10 times earnings. I think there's a lot of value there.
I'd say the same about bank stocks like Washington Mutual that has 20% earnings growth over the past decade, good growth ahead and trades at about nine times its earnings over the next year. That's not bad compared to Citigroup, where much of the company's earnings are from [market-sensitive areas like] brokerage and investment banking and the stock trades at 13 times the next year's earnings.
We also think pharmaceuticals like Bristol-Myers Squibb have been oversold. All the bad news with these stocks is out there already. [Bristol-Myers] will have 10% earnings growth over time and is trading at a discount to the S&P 500. If Bristol or Schering-Plough get much cheaper someone might step up and buy them.
To spice up the portfolio we've added smaller positions in some energy traders that are just completely hated, but aren't Enrons. Trading is just part of their business but thanks to Enron these stocks have just been knocked apart. We own Williams Cos., which is down from $38 to $8 and getting all kinds of bad publicity from California where they don't even have much exposure. Something like 85% to 90% of their earnings are from their oil and gas pipelines, not trading. Another holding is El Paso, where the treasurer just committed suicide, but they're cutting their energy trading down. Both of these companies have huge, real oil and natural gas assets and they're trading below the value and earnings power of those assets. Dynegy, another newer position, is 25% owned by ChevronTexaco Corp. and the stock was down from about $50 to about $8.
We're big in tobacco companies like Philip Morris, where they're growing at 10% a year and yielding 5%. In a market like this why struggle with a Cisco Systems that trades at 44 times earnings they paid their customers for when I can get better growth for much lower prices in the names I've mentioned?
2. On the flip side, is there a bubble in housing stocks or elsewhere in the market?
There's talk of housing being in a bubble, but I don't think so. There's still a demand and need for it that's rational. During the last housing bubble in 1990, people in California were buying two and three houses just to turn around and flip them. Now people are just buying them because they need a place to live. I don't really sense a bubble in the market today. The only extreme overvaluations I see are in tech stocks. There you see high multiples based on the idea that tech will bounce back to 1990s profits. That's just far-fetched.
3. A lot of investors are still holding battered tech stocks, crossing their fingers for a recovery in corporate tech spending. What would you say to them?
These companies' earnings aren't turning around. So if a stock drops 90% and still has no earnings growth or no earnings at all, what's it worth? We like companies with real earnings power and we can't find them in the Nasdaq 100 [an index of the 100 largest non-financial stocks traded on the Nasdaq Composite.]
Not owning tech for the next five years will help you beat the market. Ordinarily that seems like a long period, but we're coming out of the worst bubble ever. In this cold dawn these companies don't have the revenues to generate earnings growth. The telecom companies' customers are all closing down. You can't buy new equipment when you're trying to keep your creditors happy. You go industry by industry in technology and wonder where is the growth going to come from? Corporations aren't spending on servers or computers because they can get by with what they've got.
Does it look like there's an immediate turnaround for technology? No, the Nasdaq 100 is likely to lose more ground this year.
4. There's regulatory pressure on Freddie Mac and Fannie Mae right now and higher interest rates would pinch many financial stocks' profits. Are you worried about your fund's sizable bet on financial stocks?
Well with Freddie Mac and Fannie Mae there is some regulatory pressure, but that's always been there and we've owned the stocks since 1990. The bottom line is that they provide low-cost mortgages and I don't think any Congressman wants to tell their constituents that they made their mortgages more expensive. So even if they end up with some restrictions on their business, these are cheap companies and I don't question their financial strength or earnings power. [The Wall Street Journal editorial page] hates them because they're making too much money with a government monopoly.
As for rates, the stocks we buy aren't really hurt much by that. Fannie Mae and Freddie Mac are fully hedged and the banks are pretty conservative so we aren't worried.
5. You're still holding Tyco, what do you see there?
It's about 1.5% of the portfolio. It's gotten so much bad publicity, much of it earned. Sure, the company played fast with accounting rules, but when you're trading at seven times next year's earnings that seems known. We think the company is going to survive. Obviously it's been so scrutinized by the SEC for years now that I don't think there are any new secrets left. I could be wrong and no one really knows for sure, but I think if [former Chief Executive L. Dennis] Kozlowski had left on his own without scandal the stock would've gone up this week.
We're just trading in a panicky environment now with this stock and others like the energy traders. Everybody is focused on accounting and pro forma earnings that if anything we've gotten too panicky. Now if we think there might be something wrong with a company we sell it down too much. Our strategy is to buy companies where investors are panicking and we've made pretty good money that way.
For instance, we bought gambling stocks just after the horrible attacks on Sept. 11, along with Disney and American Express. Within four months the gambling stocks more than doubled. They were a small position, where they could hurt us but wouldn't hurt us a lot, but they'd still be able to improve performance.
There are several other value managers we respect and watch, and among them the Clipper fund and Bill Miller at Legg Mason [Value Trust fund] also [bought shares of] Tyco [in the first quarter.] We all got to the same place independently.
6. Are the late 1990s excesses washed out of the market yet, and should we expect stock returns below their historical 11% annual average over the next decade?
I think it's washed out in many areas, but the S&P 500's valuations are still too high, and the Nasdaq is even higher. Either earnings have to come up, or these valuations have to come down. I'd say these P/Es [multiples] aren't sustainable if earnings don't come up in the next six months. I definitely think we should plan on lower returns over the next decade. The historical average return on stocks is 11%, but there are decades where returns are higher and decades where we get less. We've just had our years of plenty.
7. If you had $10,000 to invest in a trio of stocks you had to hold for at least five years, which would you pick and why?
I'd pick Freddie Mac, Philip Morris and Washington Mutual, if not one of the big oil companies. I think these will do well over time because they're financially sound, have solid earnings growth ahead of them and still aren't expensive.
Write to Ian McDonald at ian.mcdonald@wsj.com
Updated June 6, 2002 7:45 p.m. EDT |
