In his latest Forbes column, contrarian guru David Dreman says the capital asset pricing model — long a staple of the investing world — should be done away with.
The CAPM, Dreman writes, basically says that the only way to outperform in the stock market is to take on more risk, which is usually measured by beta. “It’s time to delete the CAPM from business school textbooks,” Dreman says, adding that the theory has done investors more harm than good. “Ever since the 1980s CAPM has been widely accepted by almost all sophisticated trading and money management firms practicing Modern Portfolio Theory to price stocks,” he says. “Most of the big firms and their chief risk officers focus on beta but — at least until recently — have ignored most other types of risks. Little things like leverage and liquidity.”
Dreman says he thinks leverage and liquidity played a big role in the severity of the Crash of 1987, the market troubles caused by Long-Term Capital’s demise in 1998, and the subprime mortgage-driven crash. “In the years leading up to the 2007-08 crash leverage and liquidity were not considered risky on subprime bonds,” he explains. “After all, the beta of these bonds was relatively low, despite the garbage they were holding and the leverage they piled on. When housing prices fell, the markets collapsed.”
Rather than CAPM and beta, Dreman says investors should focus on the basic tenets Ben Graham and David Dodd laid out in their classic Security Analysis, published more than 75 years ago. “They warned investors to stay away from excess leverage, illiquidity and other risks that CAPM ignores,” Dreman writes. “They recommended buying firms with strong, identifiable earning power and stressed the importance of stockholder dividends.”
To read the full article, along with some of Dreman’s high-dividend picks, click here.