Indicator 5. An above-average dividend yield, which the company can sustain and increase

This is an important indicator and depends on indicators 1 through 4 being favorable. Because of its importance to the strategy Ill propose, lets look at it in some detail. As we have seen, conventional investment thinking about dividends is far off the mark. Current wisdom holds that contrarian stocks should provide higher dividend yields but lag in capital gains. According to the good books, the two goals are not compatible. You must go for one or the other.

What shouldnt happen, but does, as we saw cleariy in Figures 8-1, 8-2, and 8-3, is that the low price-to-earnings, price-to-cash-flow, and price-to-book-value strategies also provide considerably better appreciation dian the most favored stocks by the same yardsticks. Only the highest dividend group lags in appreciation, but still beats the market in total retum (dividends and capital appreciation).

In practice, I have found that indicator 5, an above-average and growing dividend yield, improved performance when used in conjunction with the primary mle of buying contrarian stocks.

Now that we have looked at five indicators that should prove helpful regardless of the contrarian strategy we use, Ill tum briefly to another matter. A question Im frequently asked is "What is the best approach to contrarian investing? Is it better to select one method, such as price-to-eamings or price-to-book value, and focus solely on it?" For me, the answer is no. While you can certainly select one strategy and mn with it successfully, once again I favor a more eclectic approach. Our money management firm uses the low-P/E mediod as its core strategy, but also utilizes the other three contrarian strategies extensively. Investment opportunities vary, and often you can find exceptional value with one method that does not show up as cleariy with another.

Low P/E is probably the most accessible of the four contrarian strategies, because the information on P/E ratios is available daily in the financial section of any large newspaper, next to a stocks price. The information is also updated quarterly, while price-to-cash flow or price-to-book value usually arent, because the underlying information to calculate them often is available only annually. While price-to-dividend information is also near-instantaneous, it is a secondary strategy because of the superior retums of die first diree contrarian methods. However, it too has its moments in die sun, as we shall see.

To the Trenches

Its time to move into trenches to see how contrarian decisions are made under fire. Ill draw on past recommendations Ive made in my Forbes column and to the clients of our investment counseling firm, as well as examples from the Kemper-Dreman High Retum Stock mutual fund that I manage. While one can be accused of telling "war stories," remembering only the victories while forgetting the setbacks (not to mention the routs), I think that it is important to present practical examples of how the A-B-C mles and five indicators were often clear-cut-not only with 20/20 hindsight, but at the time. Our first stop will be a couple of examples of how weve selected low-P/E stocks.

Using the Low-P/E Strategy

1. Galen Health Care

I recommended the stock in my Forbes column twice in 1993, the first time at a price of $12 in the April 26 issue. Galen, at the time one of the countrys largest hospital management companies, operated 71 hospitals in 18 states and 2 foreign countries. It became a public company as a result of Humanas spin-off of Galen stock to its shareholders in March of that year.

Humana has a rapidly growing managed health plan business (HMO), which it believed was buried under a bushel basket because of the sluggish eamings growth and prospects for Galen. Humanas management believed separating the two entities would result in a higher market valuation for its HMO business, thus the spin-off.

Galens eamings were down over 30% from their peak several years before, and the outlook was for more quarters of lackluster results before an improvement occurred. It was, in short, a blah stock.

So far, so good. On the plus side, it had a number of strong fundamentals. It was cheap measured by all three of our contrarian strategies. It had a P/E multiple of 13 on depressed eamings, which were likely to have a strong rebound in the next year because of cost cutting and more normal revenue growth. Galen was also cheap on a price-to-cash-flow basis. When measured by price-to-book value, it was in the bargain basement, priced at 1.2 times book value against 2.5 for the market at the time.

Secondly, Indicator 1 (financial strength) was solid, if not spectacular, and Indicator 2 (a fair number of respectable operating and financial ratios) was also good. Although the other indicators were mixed and the

40 -

iVu*

12/89 12/90 12/91 12/92 12/93 12/94 12/95 12/96

Source: Prepared from FactSet data.

company at that time paid no dividend, it was plainly unde riced for its industry, that until a year or two earlier had been considered one of the better growth areas. Market perceptions had done a one-eighty on the company, swinging from glowing optimism to extreme pessimism, although its outlook continued to be well above average.

Galen hit the unloved and unwanted list big time. Ignored by the market, it drifted aimlessly. Potential buyers of value had their antennae raised, however. Within months of the spin-off, rapidly growing Columbia/HCA Healthcare 11 , another major hospital management company, made a stock offer for Galen. The stock moved up 150% within months.*

* Please note that the figures quoted in this and subsequent charts are yearly averages. They may differ somewhat from figures quoted in the text, which were taken on specific days during the year.

Figure 8-5

Galen Health Care / Columbia/HCA Health Care