Summing It Up

The consistency of these studies is truly remarkable. Over almost every period measured, the stocks considered to have the best prospects fared significantly worse than the contrarian stocks, using the same criteria. This leads us to another general observation, or rule, if you like:

RULE 14

Buy solid companies currently out of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.

You might wonder: If these strategies do so well, why doesnt everyone use them? This lands us smack in the realm of investor psychology (or Behavioral Finance, as it is now called by economists).

Though the statistics drag us toward the value camp, our emotions just as surely tug us the other way. People are captivated by exciting new concepts. The lure of hitting a home run on a hot new idea overwhelms caution. The sizzle and glitz of an initial public offering like a Planet Hollywood at 140 times eamings and 13 times revenues, or a Spyglass, an Intemet search engine designer priced at 175 times estimated eamings, is just too great.°

While these are extreme examples of investor evaluation mn amok, they show why value strategies have worked so well over the years. People pay for concept, whether in the absurd cases of Planet Hollywood or Spyglass, or in consistently ove ricing the trendy industries of the day. Investors just as surely want to stay well away from companies whose outlooks seem poor.

Most investors have a negative reaction to contrarian stocks. Recall that these companies violate just about every idea of proper investment theory. "Do you know whats down there?" a major money manager once asked me, shaking his head in disapproval, "How can any pmdent man look at companies like these with such unthinkably poor visibility?"

The favored stocks, on the other hand, present the best visibility money can buy. How, then, can one recommend such a reversal of course?

The psychological consistency of the error is remarkable. There are, of course, excellent stocks that justify their price-to-eamings ratios, and others that deserve the slimmest of multiples. But, as the evidence indi-

cates, these are relatively few, and the chances of recognizing them are very small.

Contrarian strategies succeed because investors do not know their limitations as forecasters. As long as investors believe they can pinpoint the future of favored and out-of-favor stocks, you should be able to make good returns on contrarian strategies. Human nature being what it is, this edge should continue for a few years longer

We have seen how consistently contrarian strategies have worked for investors over the years. The good news for you is that this wave of discoveries provides strong evidence that there are consistent high-odds ways to beat the market. Next lets tum to how we can use these contrarian strategies to crank up portfolio returns.

Boosting Portfolio Profits

If youve felt a bit that youve been "hitting the books" in the last chapter or two, then what is next should be the change of pace you need. This is going to be a discussion with a practical and profitable mission: how to use contrarian strategies to boost portfolio results. We are going to put the theory and statistical studies weve looked at to work. Its important to understand the ideas, for as with a good college course, its not the rote information we cram that does any good, but how we leam to apply critical thinking to the subject matter.

How can you build a portfolio that should easily outdistance the market, while providing better protection when the bear growls? Since a good sell discipline is one of the hardest things to develop, what guidelines should you use to sell? The mles Ill add in this chapter and the next, while certainly not guaranteed to get you out at the top (if you know of any that do, please write) have a high probability of success. But, before figuring out when to sell to protect our profits, lets figure out what to buy. Fortunately, there are four proven ways to do this.

strategy #1: Low P/E

The low P/E strategy is the oldest and best documented of all the contrarian strategies, and the one most used by market professionals today. Although there are many ways to calculate a P/E ratio, the most common is to take reported eamings for a company (before nonrecurring gains or losses) for the last 12 months and then divide them into price. The strategy has outperformed in both up and down markets since the mid-1930s, and Hkely will for a good deal longer.