The wisdom, and courage, to not follow the crowd

In the dozen or so years that I've spent researching history's best investment strategies, one of the key things I've learned is that there's not just one way to beat the market. The investment gurus I've studied have used a variety of approaches to produce exceptional long-term returns, each employing a different set of variables and criteria to buy and sell stocks.

But while the specifics of their approaches are different, there are some overarching similarities that these gurus share. And one of the big ones is that, for the most part, these highly successful investors - from Benjamin Graham to Warren Buffett to Peter Lynch - had a contrarian streak.

There may be no better example of that than David Dreman, the Canada-born investor who has spent his very successful career swimming against the market's strong tides. In his book, Contrarian Investment Strategies: The Next Generation (which is the basis of one of my Guru Strategy investing models), Mr. Dreman offers a great look into what it takes to be a stock market contrarian - and why being a contrarian works.

A key finding of Mr. Dreman's research is that investors tend to overvalue "good" stocks (the hot, high-fliers most people key on), and undervalue "bad" stocks (those that have been falling in price and getting negative press). The hot stocks often have big expectations baked into their prices, he found, while the market's unloved often have worst-case scenarios - or something close to it - baked into theirs. Buy the hot, hyped-up stocks and there's likely not much more upside, even if their businesses do well. But one negative surprise - often in the form of disappointing earnings results - and their shares may well tumble.

The opposite is true for the market's unloved, according to Mr. Dreman. Expectations are already so low for them that poor results often don't hurt too much. A positive surprise, on the other hand, can spark big gains for their shares.

And surprises, Mr. Dreman found - particularly earnings surprises - occur frequently in the market. He thus focused on the stocks that would handle them best - the unloved stocks. Mr. Dreman identified these unloved plays by looking for firms with low price-to-earnings, price-to-book, price-to-cash flow, and price-to-dividend ratios.

Buying unloved stocks is only part of a good contrarian approach, however. That's because sometimes, a stock may be unloved for good reason: The company is a dog, and everyone knows it. Because of that, a good contrarian - like Mr. Dreman - applies other financial tests to a firm to make sure its shares are beaten down because of overwrought fears or apathy (if a firm is in a "boring" industry, for example) - not because of legitimate problems with its business.

In the end, being a contrarian isn't easy. It requires that you zig when most other investors are zagging, that you buy the stocks others fear. It's also not an approach for those seeking immediate gratification. Sometimes it can take months, or even more than a year, for other investors to realize that fear or apathy has caused them to overlook a perfectly good stock. Since you don't know for sure when that will happen, a good contrarian pick can sometimes languish for a long period before it gets the big bounce it deserves.

But, if you have the discipline and emotional fortitude to stick to a contrarian mindset, you can find some great diamonds in the rough - even in a market that's up 75 per cent off its lows. Here are a few contrarian-type stocks my Dreman-based model thinks could turn into gems.

Eli Lilly & Co.: With all the concern about the new U.S. health care bill's impact, health care stocks are a very contrarian play right now. And shares of Lilly - one of the world's largest pharmaceutical makers - seem to reflect that. It's selling for just 9.13 times earnings and 18.05 times its dividend, both of which fall into the market's bottom 20 per cent. But the firm has been growing earnings at more than twice the rate of the S&P 500 over the past six months, and it has a solid 1.95 current ratio, excellent 47.55-per-cent return on equity, and a debt/equity ratio well below its industry average, all of which earn it a 90-per-cent score from my Dreman-based model.

Exelon Corp. : Utilities have really lagged in the market rally, in part because of apathy - investors have looked to higher-growth alternatives as the economy has rebounded. As a result, this big electric utility with a $29-billion (U.S.) market cap has P/E, price/cash flow, and price/dividend ratios that all fall into the market's bottom 20 per cent. Its financials indicate it should be getting more love, however - it has a strong 22.9-per-cent return on equity, 25.5-per-cent pre-tax profit margins, and a debt/equity ratio close to half its industry average. It thus earns a solid 84-per-cent score from my Dreman model.

Ares Capital Corp. : This mid-cap specialty finance firm has increased quarterly earnings throughout the past year, has a 17.2-per-cent return on equity, and an eye-catching 8.8-per-cent dividend yield. And, with the financial sector still marred by fear, it's also selling at a price - 7.94 times earnings and 11.34 times its dividend - that makes it a solid contrarian play. My Dreman model gives the stock an 83-per-cent score.

Disclosure: I'm long Eli Lilly and Ares Capital.