I had the wonderful opportunity to interview one of my all-time favorite value guys, David Dreman, for Motley Fool Inside Value. Dreman is the author of an investing classic, Contrarian Investment Strategy, and chairman of Dreman Value Management, which manages assets for institutions and individuals. Perhaps the firm's most notable product for is Scudder-Dreman High Return Fund, which, according to Kiplinger's, has returned 12.9% per year to investors over 15 years, approximately 3 percentage points better than the S&P 500 index, and is ranked in the top 4% of funds over that period.

A 3-percentage-point outperformance might not sound like much, but the longer it compounds the better it gets. Ten thousand dollars invested 15 years ago would be worth $61,700 today if invested in the Scudder-Dreman fund, while the same amount invested in the index would be worth just $41,000.

Finding stocks that outperform
On the face of it, Dreman uses a simple strategy to screen candidates for his funds:

"We look for out-of-favor stocks by specific value benchmarks: low P/E, low price-to-cash flow, low price-to-book or high yield. Studies have shown that this strategy has outperformed the market in every decade since the 1930s."

Of course it is not quite that simple, but that's a good place to start. Dreman cautioned that some Internet sites have "Dreman screens," which list companies that meet the above criteria. However, they are not all suitable, investment-grade companies, and I asked Dreman how he sorts the wheat from the chaff.

"What we do is a pretty thorough microanalysis, fundamental analysis, and some macroanalysis, so we will screen probably the bottom half of the market. Depending on whether it is large cap or small cap, the universe is somewhat different. But we normally -- say with large cap -- we will look at the S&P, and we look at the bottom half by these various value benchmarks, and we come up with a lot of names and we screen down to about 100.

"We look for basic fundamentals. Like again, if we are using low P/E, we want really good cash flow, and low price-to-cash flow. We want to have not the highest dividend necessarily, but a reasonably high dividend with the likelihood that the company will increase it through a record of increasing it over time. We normally don't want to have debt any more than 50% of the capital structure, sometimes less. So that prevents us from getting into companies that may blow up on us.

"Another good indicator here, or something that helps us a good deal, is the fact that dividend-paying stocks, particularly if they are reasonably good and are increasing, have less chance of having accounting chicanery associated with them because the cash flow is not being manipulated."

When your share price crashes
Most investors can become quite comfortable with the buying process. However, if a stock holding drops 30%, or even less, many become nervous and don't know what to do. I asked Dreman what he does when that happens to one of his holdings.

"We as a firm have always spent a lot of time on what we call overreaction.... When there is bad news, I think the first thing we do is we step back and see how bad the news actually is. An example of that might be the Marsh & McLennan (NYSE:MMC) situation. The stock was down very, very sharply. It got as low as $23 and change. Today, it is close to $29. In that situation, you could not really assess the news very clearly because Eliot Spitzer and New York state could have put penalties on Marsh Mac as high as $6, $7, $8 billion dollars, which would really impair the company.

"In this kind of situation, you want to make sure that the company is not going to be impaired by the bad news. On the other side of the coin, a lot of reactions are just clearly and simply overreactions. Just to give you a quick example: At the same time that Marsh & McLennan was going down sharply, AIG (NYSE:AIG), which is one of the leaders in insurance, had some minor ties to the brokers. But a very small part of the business where it was all Marsh Mac, two of their executives pleaded guilty to a felony, and the stock broke something like 20%. But their basic earnings were not being impacted very much. That to us was an overreaction. We actually purchased; we increased our position pretty substantially in AIG in that crisis. We got a price in the low $50s. Now it is back close to $65."

The message here is not to panic and to look for fundamental changes to the business that may impair the company's future. Also, look at other companies that may be overly affected by the news. Keep in mind, though: The market sometimes is fairly quick to correct such an overreaction.

What stocks to avoid
I asked Dreman whether there were any stocks he would avoid at all costs.

"Well, we tend to avoid stocks that the market is really very, very taken by and the valuations are maybe two, three, four, or even 10 and 20 times what we think they should be. They will go up, and we will look foolish for a while, but what happens is they usually come down pretty hard. So in a momentum market, like those of the late '90s, momentum investors will make money for a while.

"If you take mutual funds like Janus (NYSE:JNS), in 1998 and 1999 they were beating the S&P 500 by as much as 10% to 15% per year. But if you look at Janus' 10-year record, they underperform the S&P by 4% a year. So it is a very dangerous game to play. Some people will get into a Yahoo! (NASDAQ:YHOO) or an Amazon (NASDAQ:AMZN) very early on and make a ton. But for every one of those companies, there are probably 100 or 200 that won't work. They may work for a couple of years, but very few people are smart enough to get out at the right time. You see a stock double, and then double again, and then double again and double again, and you think it is going to go on forever, right? And it doesn't.

"So when we look at just sheer probabilities, the chance of making money this way is really very low. Some people will make money; a very small percentage will make money in these kinds of stocks over time. But most people will make some money at the height of a mania, but they will lose it all and much more on the way down."

When to sell
Most investors have a real problem with when to sell a stock, selling either too soon or too late. Some say the time to sell is almost never. The Motley Fool has long advocated just a few reasons for selling:

  • The company's fundamentals deteriorate.
  • You made a mistake in your analysis.
  • There's a better investment for your money.
  • You need the money for another purpose.

I asked Dreman to walk through his sell criteria.

"The sell criteria are probably the hardest there are. Ours are fairly simple. We buy out-of-favor stock. So when they get to the market multiple -- say we are buying low P/E stocks -- when the P/E gets to market multiple, we start to sell and usually complete our sales within six or eight months. Time back was, when we first started, we would have sold immediately, but we find that usually there is somewhat more momentum when stocks get popular. They go farther than we would originally think. So we sell when we reach the market multiple, would be one rule.

"A second rule is that if money managers -- including us earlier on -- like a stock, and it looks like it has excellent fundamentals, or the same thing goes for an industry, they will tend to want to hold it, even though the stock or the industry has a fair amount of negative news. If the company doesn't outperform within two-and-a-half to three years, we sell the stock regardless of how good it looks on paper. We have found that a lot of people or a lot of managers have stocks that they really get very emotional about or sentimental about, and they won't sell them. This stops us from just being loaded with companies that have not had good performance, may not have good performance in the future, and we move on to something else in the contrarian area.

"The third rule we have is that if there is unexpectedly bad news, not a bad quarter but something that really will have a major impact on the future of the company in a negative sense, we will sell the stock immediately, regardless of what we paid for it."

I would vary Rule No. 1 for some companies that have long-term competitive advantages: Personally, I would prefer to hold such companies.

Hopefully, those contrarian ideas give you some sense of why I'm such a big fan of his. But that's just the tip of the value iceberg. In my commentary next week, Dreman names names and I'll share some of Dreman's insights on specific stocks and industries. If you can't wait that long, or if you want to see the raw interview, I invite you to take a 30-day FREE trial to Motley Fool Inside Value.