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Profiting From Other Investors' Pessimism

Dreman Looks for Companies With Low P/E Ratios, Above-Average Dividends

By Edgar Ortega
Bloomberg News
Sunday, February 13, 2005; Page F04

David N. Dreman was among the biggest beneficiaries when cigarette manufacturers won a court ruling blocking the U.S. government's claim to $280 billion of past profits.

His $6.1 billion Scudder-Dreman High Return Equity Fund has 10 percent of its assets invested in Altria Group Inc., whose Philip Morris USA unit is the world's largest maker of cigarettes. The fund's performance ranks first of 113 large-company stock funds tracked by Bloomberg in the past 10 years.

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The tobacco industry won a landmark victory Feb. 4 when a panel of an appellate court in Washington sided with the companies, ruling that the forfeiture of profits wasn't authorized under the law. The Justice Department claimed the industry had misled the public about the dangers of smoking for five decades. Tobacco executives said the award, the biggest in history, would have bankrupted them.

"The litigation terrifies the market, but when we look at it, it isn't as severe as people think," said Dreman, 68, in a telephone interview from his office at Dreman Value Management in Jersey City, N.J. "We spend an enormous amount of time looking at the litigation."

Altria's stock has risen 8.7 percent this year and more than doubled since 2000, when Dreman first bought shares of the company. It closed Friday at $66.20 a share. Dreman's fund has a higher percentage of assets invested in Altria than all mutual funds with more than $100 million to invest, according to Morningstar Inc., the fund-industry research firm in Chicago.

Reynolds American Inc.'s R.J. Reynolds Tobacco, Freddie Mac and Fannie Mae are among the Dreman fund's 10 largest holdings.

The court decision brings Altria a step closer to splitting into two or three units. Altria may spin off its Philip Morris and Kraft Foods Inc. divisions "when the litigation environment permits," chief executive Louis C. Camilleri told investors in November.

"That's going to be very good for shareholders," said Dreman, whose firm is the 21st-largest Altria shareholder. "I wish we had more bets like that."

Dreman has described his "contrarian" investment strategy in four books, as well as in a column published by Forbes magazine for more than two decades. The fund manager tries to make money from investors' pessimism about companies that he perceives as having improving prospects. As a "value" manager, he initially seeks stocks with low price-to-earnings ratios that pay above-average dividends.

His success depends on an ability to avoid companies whose shares have gained from excessive optimism. Those stocks don't produce profitable investments in the long run, Dreman said. The fund typically holds fewer than 55 stocks at a time.

"There is a tremendous herd mentality in the financial markets, and David doesn't need the crowd with him," said Brian Bruce, head of equity investments at Boston-based PanAgora Asset Management Inc., which oversees $18 billion. "He has a process that produces a higher percentage of winners."

Bruce met Dreman in 1995 at an investor conference. They now work together on the editorial board of the Journal of Behavioral Finance, a quarterly publication devoted to research on financial markets and investor psychology.

The Scudder-Dreman fund has climbed at an average annual rate of 15 percent in the past 10 years. The fund rose 12.7 percent in the past 12 months, compared with 7.6 percent for similarly managed large-cap funds, Bloomberg data show.

Dreman started his career in 1958 as an analyst at his father's commodities trading firm in Winnipeg, Manitoba, after earning a degree in business administration at the University of Manitoba. Before founding his own firm, Dreman was head of research at Rauscher Pierce Refsnes (now RBC Dain Rauscher) from 1976 to 1978, and a money manager at J&W Seligman & Co. from 1967 to 1975.

While keeping an eye on the tobacco trial, Dreman has had to deal with crises at other companies, most notably Fannie Mae, Merck & Co. and Pfizer Inc. Share-price declines during the past year have tempered his fund's returns, yet he expects a rebound.

"Our firm has always tried to take advantage of investors' overreactions," Dreman said. "As Peter Lynch says, you're doing a great job if you get six out of 10 right."

Lynch, 61, oversaw the Fidelity Magellan Fund, which ranks among the world's biggest stock funds, for 13 years until 1990.

Shares of Fannie Mae, the fund's third-largest holding, tumbled 15 percent in the week ended Sept. 25 after regulators found the company had misapplied accounting rules in order to smooth earnings. The stock ended the week at $62.42. Fannie Mae, the biggest provider of money for the U.S. mortgage industry, ousted its chief executive and chief financial officer in December.

Smaller competitor Freddie Mac has jumped 37 percent since June 2003, when it fired its top three executives after a restatement of financial results. Freddie's stock closed Friday at $64.36.

"Freddie was faster at cleaning house, and Fannie and its board have been a little sluggish," said Dreman, who owns shares of both companies. Dreman said he has held on to all of the 8.1 million Fannie Mae shares he owned before the regulatory probes were revealed.

For Fannie Mae, "it's time to bring in top-notch management, it's time to cut executive salaries back and think about shareholders," he said.

Dreman also has retained positions in Pfizer and Merck, the world's No. 1 and No. 3 drugmakers, respectively. The stocks finished 2004 near their lowest level in at least seven years because of concerns about the safety of their painkillers and competition from generic drug manufacturers. Pfizer ended the week at $25.15, while Merck closed at $29.21.

Merck shares plunged 27 percent on Sept. 30 when the drugmaker recalled its Vioxx pain medication because of a potential link to heart attacks and strokes. Pfizer said less than two months later that its Celebrex drug also increased the risk of heart attack in some patients.

"There might be a little bit more bad news here," said Dreman, whose firm manages about $11 billion. "But if we thought that nothing good was going to happen to the stocks for another two or three years, we wouldn't hold them."

Pfizer's expenditure of $7.68 billion on research last year is likely to yield new medications, Dreman said. Merck shares may get a lift as the drugmaker settles some of the 575 lawsuits from plaintiffs' groups alleging injuries from Vioxx, he said.

Dreman, who last year almost doubled his holding in ChevronTexaco Corp., expects energy companies to be among his best-performing stock holdings. ChevronTexaco shares sold for an average 12 times earnings last year, lower than the Standard & Poor's 500-stock index's average ratio of 21, and closed Friday at $58.16.

The lower price-to-earnings ratio is a reflection of investor pessimism about energy companies' growth potential, Dreman said. Crude oil futures are 40 percent higher than a year ago, in part because of growing demand from China and India.

"There is a fundamental change in energy from the late 1990s," Dreman said.

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