The hallway leading to the Jersey City, New Jersey, waterfront offices of legendary investor David Dreman is slightly faded and indistinct, befitting a man who has spent most of his life searching for stock bargains. A small sign on the prosaic brown door reads “Contrarian Services Corp.” -- a reminder that Dreman does not follow the crowd. Inside, a glass-encased, handmade model sailboat -- sailing is one of Dreman’s passions -- brightens an otherwise drab foyer.
It’s not the setting you would expect for a firm readying itself for a major hedge fund push. But then Dreman’s decision to follow many of his long-only competitors into hedge funds is equally unusual for a man who built his career on an unconventional approach to long-term investing and who is as active in the world of academia as he is in the markets.
Institutional and retail investors have been entrusting their money to Dreman Value Management, and its founder in particular, since the firm’s 1977 launch. Dreman’s standing among mutual fund investors is almost iconic -- his name is synonymous with his knack for identifying bargain stocks and his practice of holding those securities until the market stops punishing them. In 2000 he moved into tobacco stocks amid mass litigation in the sector, and he embraced Bermuda-based conglomerate Tyco International at the height of former CEO Dennis Kozlowski’s 2002 embezzlement scandal. He is also a widely published author, having written three books on investing and contributing regularly to various media outlets.
Yet at the age of 71, Dreman is shaking things up. Renowned for his contrarian investing approach, he’s now following the crowd of mutual fund managers flocking to hedge funds, and he’s making his move a grand one. Dreman Value Management, which boasts $22 billion under management as of mid-May, is launching what it calls the Dreman New Wave Contrarian Hedge Fund -- a suite of 12 long-short products, the first of which, a market-neutral fund, began trading in January with $5 million.
“We’ve always had a two-engine plane, but we’ve used only one engine,” explains Dreman. “Now we’re going to double our power by being able to short stocks.”
Dreman says hedge funds are a natural extension of his business, allowing him to better utilize his firm’s analytical abilities. In the past his investments have focused on stocks with low price-earnings ratios that his research and analysis identified as undervalued and likely to rise. Now he plans to profit as well by shorting high-P/E stocks that are likely to fall.
Dreman’s new tack is not without challenges. Managing hedge funds requires a different skill set and capabilities than those that Dreman has relied on, and changing course so late in his career raises succession concerns. He is also venturing into hedge funds when the market is already crowded. To address those issues, Dreman has been busily building up his management team to free himself from some of the day-to-day responsibilities for the firm’s long-only investments so he can focus on its new business. To attract investors, he is counting on his track record in traditional asset management as well as on his experience successfully managing two small hedge funds -- the Dreman Contrarian Hedge Fund, started in 1999, and the Dreman High Opportunity Hedge Fund, which launched in 2003.
Although the hedge funds’ individual management strategies will vary, the entire collection will adhere to Dreman’s career-long devotion to what is now known as behavioral finance -- the study of how psychological factors influence investment decisions.
Dreman’s dedication to behavioral finance has been profitable for investors. The DWS Dreman High Return Equity Fund is the top-performing equity-income mutual fund of the past 18 years, according to New Yorkbased research firm Lipper. In 2006 it was up 18 percent, yet wasn’t the top-ranking fund; as Dreman says, more aggressive, higher-beta cyclical stocks that the fund doesn’t own were skyrocketing. Comparatively, the Standard & Poor’s 500 returned 15.8 percent in 2006.
Behavioral finance will also be central to the New Wave Hedge Fund platform. Dreman Value Management hopes to raise $2 billion to $3 billion among the 12 funds during the next three to five years.
“This is the next generation of contrarian investing,” says CEO Boris Onefater. “It’s the basis of David’s life’s work.” Onefater joined Dreman Value Management as chief operating officer in 2006 from Deloitte & Touche, where he headed the New Yorkbased accounting firm’s hedge fund practice; in May he was promoted to CEO (he retains the COO title). He is one of several seasoned investment professionals recently brought in to help with the expansion into hedge funds.
Other additions include E. Clifton Hoover, the firm’s first cochief investment officer and co-manager of large-cap investing, and Mark Roach, who has been charged with managing small- and midcap mutual fund investments and will also have a hand in generating investment ideas for the hedge funds. Hoover joined late last year from $33.8 billion Dallas-based NFJ Investment Group, where he was CEO, CIO and manager of a dividend-value portfolio and a small-cap portfolio. Roach was hired from Houston-based Vaughan Nelson Investment Management, where he managed a small-cap value product -- a fund he grew to $1.5 billion from $30 million. Roach wasn’t looking to change jobs, but notes, “When one of the world’s greatest investors calls you, you go in and talk.”
Dreman’s decision to build out his hedge fund business is anything but contrarian. Roughly 150 mutual fund managers now also run hedge funds, according to Chicago-based data provider Morningstar. Lured by higher fees and the ability to employ hedging strategies, leverage and short selling, such managers believe that their experience on the long side can be translated into success running long-short funds. But that’s often not the case.
“You don’t want to be the first patient for a surgeon, and you don’t want to be a long-only investor’s first hedge fund client,” says Russell Fuller, president and founder of $3.5 billion San Mateo, Californiabased investment advisory firm Fuller & Thaler Asset Management, who oversees roughly $3 billion in long-only investments and $425 million in long-short institutional separate accounts.
Like Dreman, Fuller is a practitioner of behavioral finance and has straddled the line between the business world and academia throughout his career. Before founding his firm in 1993, Fuller served as chairman of the finance department at Washington State University. He says shorting stocks is far more complicated than buying and holding them and that most mutual fund managers lack the necessary experience to successfully employ short strategies within their portfolios.
Dreman, however, is not a newcomer to shorting. His $48 million long-short Contrarian Hedge Fund, essentially the best of David Dreman, has delivered annualized net returns of 11.6 percent since its 1999 launch, besting the Hedge Fund Research equity hedge index’s annualized return of 10.33 percent. The $6 million long-short High
Opportunity Hedge Fund has delivered net annual returns of 12.9 percent since its October 2003 inception, compared with 11.83 percent for the HFR index during that time.
Convincing investors that he can duplicate his initial hedge fund performance on a much larger scale won’t be easy. Still, the longtime contrarian’s push into hedge funds, says Morningstar managing director Don Phillips, comes at a time when institutions are becoming more influential, and Dreman is a name with which they are familiar.
“Institutions will increasingly want to invest with a name they know,” says Phillips, who has been following Dreman since joining Morningstar as its first mutual fund analyst in 1986. “Dreman is going to have a huge advantage, particularly when it comes to pension funds that need to defend their hedge fund picks to their boards.”
avid Dreman’s fascination with financial markets began when he was a child growing up in western Canada. The son of a commodities trader, Dreman decided at an early age that he wanted to follow in his father’s footsteps. After receiving a business degree from the University of Manitoba, Dreman went to work as an analyst for his father’s Winnipeg-based commodities trading firm in 1958. In the mid-1960s he was offered a senior analyst position with New Yorkbased J. & W. Seligman & Co. and moved to Wall Street. He remained with Seligman until 1975, when he jumped to Rauscher Pierce Refsnes (now Minneapolis-based RBC Dain Rauscher) and led that firm’s research efforts until launching his own shop in 1977.
It was a September 1972 article in the Journal of Finance that had the biggest impact on Dreman and has shaped his career. The piece, by Paul Slovic, then a research psychologist at the Oregon Research Institute in Eugene, touched on some of the psychological factors that influence people’s approaches to money and investing, such as the misperception that the length of an analyst’s experience influences the accuracy of his or her judgments. Dreman contacted Slovic for more information, beginning a relationship that continues to this day.
Behavioral finance is grounded in the idea that investment decisions are often based on emotions and beliefs, instead of tangible data or facts. Investors’ actions can be influenced by the way data or investment opportunities are presented, or simply by the actions of others. Research by Slovic and other academics has found that people are overconfident in their judgments, hang on to past beliefs too long and give too much weight to attention-grabbing information. Based on these findings, researchers have identified patterns of predictable investor errors -- mistakes Dreman says are so common that knowledgeable investors can profit from them.
Dreman was an early adopter of behavioral finance, incorporating it into his investment philosophy: that low-P/E stocks produce significantly better long-term returns than high-P/E ones. He says a 1970 investment of $1 million in a basket of low-P/E stocks would be worth $228 million today, as opposed to $23 million for the same investment in a basket of high-P/E stocks.
“David was a pioneer in contrarian investing, recognizing the importance of behavioral factors long before they were respectable in finance,” says Slovic, now a professor of psychology at the University of Oregon in Eugene and the president and founder of Decision Research, a nonprofit research institute in the same city. “Investors quickly size up the world through images, associations, names of companies -- feelings that might be more influential than fundamental analysis.”
In the early 1970s, finance theory was dominated by the efficient market hypothesis -- the assumption that investors’ decisions were rational and based on all publicly available information. Large-scale research into behavioral finance started taking off only in the mid-1980s. (It wasn’t until 2002 -- 30 years after Slovic’s article -- that Daniel Kahneman, a professor of psychology and public affairs at Princeton University’s Woodrow Wilson School of Public and International Affairs, and Vernon Smith, a professor of economics and law at Virginia’s George Mason University, were awarded the Nobel Prize for their work in behavioral finance.)
Those who know Dreman best think his analytical nature and focus on investor behavior will lead to success in his latest venture. “David’s a quiet guy,” says Arnold Wood, president and CEO of Boston-based quantitative institutional manager Martingale Asset Management. “He’s not flamboyant, or a public speaker, and he’s certainly not a flamboyant hedge fund manager.” A longtime friend who shares Dreman’s passion for skiing, Wood describes Dreman as stoic and prudent, characteristics that lend themselves to controlling risk -- an important quality for a hedge fund manager. “He even bought his house in Colorado out of the Resolution Trust Corp.,” says Wood, referring to the management company set up by Congress in 1989 to liquidate assets of failed savings and loans.
Such frugality is at the heart of Dreman’s concentration on earnings surprises. Because he believes valuations often go to extremes -- stocks that are strong performers tend to be overvalued, whereas poor performers are frequently undervalued -- Dreman says earnings surprises present moneymaking opportunities.
“People are shocked by earnings surprises, even though they are common,” says Dreman. “We know it’s a behavioral quirk.” He explains that investors tend to make errors because they process only a portion of the information with which they are inundated. He also believes earnings predictions themselves are flawed, as analysts tend to be overly optimistic when estimating companies’ chances for success.
liff Hoover keeps a four-foot-long hammered steel sword, replete with medieval adornments, next to his desk at Dreman’s Jersey City offices. Not long after Hoover arrived at the firm as co-CIO in December 2006, David Dreman gave him what’s known within the firm as the “keep the low-P/E faith” sword, knighting him as his eventual successor. The significance of the gift has not been lost on Hoover, who like Dreman has built his career on low-P/E investing and is a big believer in behavioral finance.
Hoover is a natural fit at Dreman Value Management, having long embraced Dreman’s take on behavioral finance, which has centered on the tendency of investors to overreact to earnings surprises or to news on specific companies or sectors -- both positive and negative. The firm scours the market for anomalies, such as the run-up in technology stock prices that preceded the bursting of the dot-com bubble. In Contrarian Investment Strategies: The Next Generation, his third book on behavioral finance, Dreman likens the collective behavior of investors to a crowd in a theater that’s on fire.
“Most investors rush for the same door at once, and many get trampled,” writes Dreman. He is so passionate about behavioral finance that in 1990 he established the Institute of Behavioral Finance, a Jersey Citybased organization devoted to studying the impact of psychology on investor decision making, in which he has invested more than $2 million.
One area he is currently focused on is emerging research on “affect” -- which relates to the belief that individuals process information not just analytically but also intuitively. Affect is the ability to sense whether something is good or bad, a crucial skill when humans were hunters and gatherers and had to decide quickly whether certain animals were dangerous. Those days are gone, but intuition still plays an important role in decision making. “Images, associations, names of companies and feelings can be more influential than fundamental analysis,” says Slovic.
Fuller & Thaler Asset Management’s Fuller likens affect to the heuristic biases and shortcuts the brain uses to solve complex problems, adding that first impressions are typically correct. “Your brain is not looking at every piece of data, just a few salient pieces,” he says. “If it looks and quacks like a duck, it probably is.” Although the market usually gets it right eventually, such gut-based decisions can lead investors to make mistakes that present opportunities for savvy fund managers. As Fuller explains, when investors incorrectly interpret new information in the market, they make bad forecasts, have faulty expectations and misprice stocks.
To put behavioral finance to work, Dreman Value Management uses computers to screen for stocks in the bottom quintile of publicly traded companies based on P/E. Those stocks are then researched to see if they deserve their low valuations, or if the market is overreacting to news. “We turn each company inside out to make sure we’re buying a temporarily undervalued stock,” notes Hoover. He says company P/E ratios, relative to their valuation histories and to such market measures as the Standard & Poor’s 500 stock index, are also reviewed.
Last summer Dreman bought shares of Minnetonka, Minnesota based UnitedHealth Group after the firm’s research determined that the market was overreacting to the discovery that the company’s CEO had been receiving backdated stock options for years. “We love headline risk, especially when it involves nonoperating issues,” says Hoover. “The volatility and pessimism that results leads to opportunities for us.” After news coverage of the stock option fraud sent UnitedHealth Group shares plummeting 35 percent, to a 52-week low of $41.44, Dreman started buying. The stock was trading at about $53 in mid-May.
Shorting is the mirror image of the process. Dreman searches the top P/E quintile for companies that may be overvalued. The firm also looks for short-term catalysts that could cause a stock to fall. Last year Dreman shorted the stocks of several homebuilders after the firm’s research determined that their earnings had peaked. Many of the stocks were trading at nine or ten times earnings, and Dreman felt they were ready to fall -- which is exactly what happened. “Somebody who didn’t know what they were doing may have thought those stocks were still undervalued,” says Hoover. “The art is to evaluate the ‘E’ in a P/E and make sure it is sustainable.” In the case of homebuilders, he says a herd mentality within the market was keeping the stocks artificially high.
Small- and midcap manager Roach is already employing Dreman’s behavioral investing approach in his search for shorting opportunities in what he calls story stocks -- cases where investors tend to dismiss valuation concerns because their judgment is clouded by the buzz surrounding a company. “Often in these cases, investors calculate growth in a way to justify the multiple and leave little room for error,” says Roach. “People assign high P/Es to earnings numbers that are subject to revision and error.”
Dreman is looking for ways to apply behavioral finance beyond equities. “The contrarian view can span all asset classes,” says Peter Andersen, who has taken over management of high-yield products and is helping Dreman launch a credit-enhanced hedge fund that invests in fixed income. Andersen, a self-proclaimed contrarian, joined the firm in November 2006 from Boston-based Congress Asset Management Co., where he was on the equity and fixed-income investment policy committees.
Rounding out the management changes, Dreman has promoted James Hutchinson to president. A longtime friend and colleague who joined the firm from the Bank of New York in 2000, Hutchinson has been a managing director and coportfolio manager of the DWS Dreman High Return Equity Fund -- a role he will continue to play.
Dreman has also devoted significant attention to the systems that will support his firm’s new hedge fund offerings. Onefater, the new CEO and COO, has been busily beefing up infrastructure, including systems and technology. He has hired New Yorkbased fund administrator Columbus Avenue Consulting (Dreman wanted a boutique that would cater to his firm and wanted to bring in the services of Joe Holman, an experienced hedge fund accountant at Columbus and the firm’s founder), is building a middle-office hedge fund platform and is searching for a performance attribution system, as well as a trade order management system with compliance features. Dreman Value Management is planning a road show in the near future.
The 12 Next Wave Hedge Fund strategies will represent variations on large cap, midcap, small cap and “smid” -- small-to-mid-capitalization. In addition, different amounts of leverage will be used to further differentiate the funds. Marking a departure from his previous domestic-only long investments, Dreman plans to invest globally, with a focus on Europe and developed Asia. He believes that foreign markets are less efficient than those in the U.S. and will likely produce more opportunities. In backtests of the data covering 30 years, the New Wave Hedge Fund returned 16 percentage points a year over the S&P 500 index when unleashed over the entire globe.
Such departures will no doubt open Dreman to scrutiny from his retail investors and blue-chip institutional clients, particularly when it comes to potential conflicts involved in allocating trades and ideas between mutual funds and hedge funds, with their very different fee structures. In October 2004 the Securities and Exchange Commission adopted a rule requiring that fund managers engaged in side-by-side management of mutual funds and hedge funds must disclose that fact to investors. The SEC has yet to take further action but has warned investors that the practice could result in fund managers’ showing preferential treatment to hedge funds -- such as in the allocation of IPO shares -- because of the bigger payoff the hedge funds’ higher fees mean for them.
The potential for such conflicts is not lost on Onefater. He is hiring two compliance staffers to supplement Dreman Value Management’s chief compliance officer and bringing in an outside auditor to double-check the team’s work. “I’m making sure the foundation is solid,” says Onefater, who insists any conflicts will be minimal because the strategies of the long-only funds are different enough from the hedge funds that there will be little overlap between stock picks.
Nonetheless, some onlookers are skeptical. Todd Cipperman, an attorney with Philadelphia-based Cipperman & Co. specializing in regulatory issues involving investment management, says trade allocation will be a serious issue for Dreman. “Which fund is more likely to get the benefits of a particular investment opportunity?” he asks.
Dreman may also face challenges in persuading investors that the success of his long-only approach can be translated to hedge funds. Philip Stapleton, president and CEO of San Franciscobased hedge fund administrator Conifer Securities and a veteran of the hedge fund industry, says he has reservations about long-only investors moving into hedge funds. He believes hedge fund managers need on-the-ground capabilities around the world to analyze global markets and must be well versed in trading derivatives.
Ever the contrarian, Dreman intends to prove the skeptics wrong by demonstrating his behavioral finance approach can be translated to hedge funds. Although his push into hedge funds is anything but unique, his approach to managing them is sure to be.
