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Battered investors - and prime opportunities

Famed contrarian value investor David Dreman declared in July that investors were missing out on some terrific stock market bargains because they were suffering from a bad case of what he called battered investor syndrome.

He described BIS as "a form of slow psychological torture that can eat away at your confidence and your portfolio." At the time, the euro zone appeared in danger of coming unglued, a seemingly unstoppable oil spill in the Gulf of Mexico was making daily headlines, and a dreaded double-dip recession loomed just around the corner. We had also seen the Great American Flash Crash of May 6, a shocking plunge triggered by a wave of automated selling that wiped out billions of dollars in market value in a matter of minutes.

As Mr. Dreman told readers of his Forbes magazine column: "It makes you want to just sell stocks and curl up in a fetal position."

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But all that was before global equity markets began a nice little run in September that has mostly stretched deep into October, thanks to a string of better-than-forecast corporate profits, receding fears of another U.S. recession, modest signs of some financial stability in euro land, strong growth in key emerging markets and expectations that Ben Bernanke and his crew are about to turn the money faucet wide open. The permabears will have to wait a bit longer for the grim reversal they keep predicting.

So we checked in with Mr. Dreman the other day to get his latest temperature reading, and it turns out that ordinary investors are still caught in the syndrome's icy grip. "Investors are battered," he said. "They are still very disenchanted" - as the continuing flight from U.S. equity funds illustrates. "A fair amount of our money is also flowing abroad."

Investors yanked a net $1.9-billion (U.S.) out of U.S. stock funds in the third week of October, much of it earmarked for emerging markets, which have been flooded with record amounts of cash.

Mr. Dreman is also a firm believer in diversification, but says that shouldn't mean ignoring a raft of stock deals at home.

After more than 40 years in the business, about 30 of them running his own shop, the 74-year-old Winnipeg native is leaving his post as co-chief investment officer of Dreman Value Management in Jersey City, N.J., at the end of the month. Although he's stepping off the daily merry-go-round, he is not following some of his more frustrated contemporaries into retirement.

Stocks Are Still Cheap

In markets that have caused some veterans to throw up their hands in despair, he remains faithful to his essential strategy of snapping up what he regards as undervalued but good-quality, large-capitalization stocks in sectors running the gamut from materials and resources to health care, tech and consumer products. Indeed, he will continue managing two small funds that do just that, including the wonderfully named Dreman Market Over-Reaction Fund.

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The payoff may take years, but he says he can wait. "Over 30 years, I've heard this many times: 'Well, it doesn't work any more.' It can be out of favour, but it really is based on pretty modern investor psychology. Unless human nature changes, it should work over time."

Stocks are still cheap by traditional guidelines and will get even cheaper if his prediction of rising inflation comes true down the road, Mr. Dreman insists. The forward price-to-earnings ratio of the S&P 500 sits at 12.7, even after a runup of nearly 10 per cent since August. The norm over the past century has been closer to 16 times earnings.

Deep Value

As a seeker of deep value, he has long scoffed at the now largely discredited theories of efficient markets and rational investors, noting that he has made his living by investing in market inefficiencies.

"Basically, these assumptions assume omniscient rationality - the idea that all investors will price stocks just right. And they believe there's always going to be a buyer for every seller. That's just not the case."

The problem with focusing on out-of-favour stocks "is that, unlike the casino, there is no instant gratification," he said. The unloved stocks can stay that way for years. Most market pros can't afford such a long wait because they face severe pressure to deliver better results quarter after quarter.

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What will it take to bring people back to the casino, er, market?

"There's one thing that always does that, and that's a rising market," Mr. Dreman said with a laugh. "If human nature hasn't changed, they have to see a market that's going to be up pretty significantly over a few years. Then, at some point, people start rushing back in. But there are absolutely no signs of anything but redemptions at this point."

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