This article on mean reversion and deep value investing was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by charlemagne, edited by Broken Leg Investing.
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Mean Reversion - Tobias Carlisle’s Not-So-Secret Sauce
The idea of mean reversion* is arguably the most overlooked aspect of equity investing today. Both institutional and retail investors often spend so much time obsessively searching for subjective signs of quality that the question of whether the stock is actually cheap is forgotten. In his book Deep Value (chapter 5, “A Clockwork Market”), Tobias Carlisle discusses mean reversion and explores its impact on the performance of businesses and stock prices.
“By putting the words, ‘Many shall be restored that now are fallen and many shall fall that now are in honor’ on the facing page of Security Analysis, Graham gave the most prominent position in his seminal text to the idea that Fortuna’s wheel (of fortune**) turns too for securities, lowering those that have risen and lifting those that have fallen. The line, from Horace’s Ars Poetica, echoes the phrase spoken by the wise men of legend who boiled down the history of mortal affairs into the four words, ‘This too will pass.’ This is regression toward the mean.”
As Tobias points out, the relationship between mean reversion and investing is not a new idea. With Benjamin Graham highlighting the link between the two in his book, The Intelligent Investor, as far back as 1949, it is clearly not something that should come as a surprise to investors today. Mean reversion, as a more general concept, traces back long before this. The earliest statistical version of the concept dates back to the 18th century with Sir Francis Galton and his work, “Regression Towards Mediocrity in Hereditary Stature.”
The Origins Of Mean Reversion
Metaphorically, however, the idea of mean reversion goes back much further. The term “This too shall pass” allegedly dates back to Persian Sufi poets’ writings between the 11th and 14th centuries. Referring to the temporary, ephemeral, or transitory nature of the human condition, the phrase essentially means that the only guarantee in life is that all things will change. Taking this idea further — if every aspect of the human condition is bound to change, and financial markets are entirely controlled by humans (or algorithms that were designed by humans!), then how can investing be any different? The answer, of course, is that it can’t.
“… value strategies are contrarian to the ‘naïve’ strategies followed by other investors who, like the asses clinging to the wheel in Durer’s woodcut (the Wheel of Fortune), fail to fully appreciate the implications of mean reversion. Here naïve strategies might range from extrapolating past earnings growth too far into the future; to assuming a trend in stock prices; to overreacting to good or bad news; or to simply equating a good investment with a well-run company irrespective of price. Some investors get overly excited about stocks that have done well in the past and bid them up, so that these so-called glamour stocks become overvalued. Similarly, they overreact to stocks that have performed poorly, oversell them, and these out-of-favour so-called value stocks become undervalued.”
As Tobias makes clear, the core factor that separates a true value investor from all other investors is that the average investor — be they institutional or retail in nature — has chosen to jump aboard Fortuna’s wheel of fortune. The value investor, however, perfectly aware of the mean-reverting nature of financial markets, takes advantage of these “asses” and uses their foolishness as a means to gain a leg up. The strategies to which Tobias refers as naïve are in fact the most oft-used and popular strategies in the industry. For example, the Discounted Cash Flow (DCF) method of stock valuation is championed by some of the best minds in finance and valuation (for example, Aswath Damodaran) and seen as the best and most accurate technique by equity research analysts — many of whom hail from some of the most prestigious colleges and universities across the globe.
Ignoring Mean Reversion Will Hurt Your Portfolio
What the author sees as naïve is the attempt by these analysts, regardless of — and perhaps due to — their IQ, to extrapolate earnings five and even ten years into the future. The message here is that no matter what school you attended, nobody can make accurate predictions about a company’s earnings that far into the future. In addition, and as per Tobias’ statements above, the inclination of people to assume that trends will continue, to overreact to news, and to get emotionally attached to positive and optimistic stories are all examples of irrational behaviour that all humans tend to display.
Tobias correctly points out that none of these traits, which ignore the reality of mean reversion, are conducive to making good investment decisions. Knowing all of this, why do investors and analysts continue to ignore the reality that mean reversion is pervasive throughout all aspects of human life, including stock investing?
“If we are aware that value stocks outperform glamour stocks, why is it that investors continue to favour glamour stocks over value stocks? One possible explanation suggested by Lakonishok et al. is that investors simply do not know about the phenomenon. Benjamin Graham’s advocacy of value investment strategies, beginning at least 80 years ago with the publication of Security Analysis, and the wild success of his most famous pupil, Buffett, makes this highly unlikely. Buffett has written at length since the 1960s, describing his process and his influences. A more plausible explanation is that investors prefer glamour strategies to value strategies for behavioural reasons. As we’ll see, this is not a phenomenon unique to lay investors. De Bondt and Thaler found ‘considerable evidence’ that professional security analysts and economic forecasters tended to display the same so-called ‘overreaction bias.’“
Mean Reversion Is Often Counterintuitive
Tobias ends the conversation on mean reversion by answering his own question — the reason that professional and retail investors don’t adopt value investing strategies is that it’s difficult! Imagine you have just been hired as a junior analyst at a prestigious fund. Now imagine that you take your next big idea to your senior, and the majority of your research is based purely on quantitative data.
Where is your qualitative data? Where is your value added? How are we supposed to beat the market if we don’t apply our irrational and subjective thoughts to the objectivenumbers? — Sarcastic Voice
It just won’t fly! The analyst community prides itself on delivering alpha (i.e., above-market returns). As soon as their employers figure out that on average, analysts don’t provide this qualitative alpha (because very few people can), some people could be out of a job — and in fact, with the rise of quantitative-driven funds, this has already begun.
Let us even ignore value investments for a moment. In his book Margin of Safety, Seth Klarman points out some other reasons that analysts and funds tend to overlook non-household names. The biggest reason is fear. By going against the crowd and adopting a contrarian stance, one is opening themselves to what might be unwanted attention. If an unpopular decision works out, then you will be praised, but if it goes against you just a few times, then you risk being shunned by the rest of the community — and your clients.
If an analyst can’t sell their research, then they won’t get paid. As a result, and driven by an understandable risk aversion, analysts would prefer just to avoid rocking the boat. Now, we begin to understand why Facebook, Apple, Amazon, Netflix, and Google are popular choices for the community, and maybe also why momentum investing is an actual strategy (when something becomes popular, it usually becomes even more popular — until it isn’t anymore).
Finally, there is no doubt that scale and regulatory restraints also help to provide value investors with a rich hunting ground. As funds grow in size, their ability to invest in companies with smaller market capitalizations diminishes. This is because, due to their size, there aren’t sufficient shares of that company that are traded on the stock exchange for them to purchase in order to make any sort of impact on the fund’s performance. Add to this the fact that regulatory measures demand that large wealth managers such as university endowments and pension funds be prescribed minimum limits/volumes of “high-quality” investments. These are points that both Klarman and Warren Buffett have touched upon in the past.
From the outset, we made the argument that mean reversion, a natural phenomenon that is pervasive through many aspects of life, is no less present when it comes to equity investing. Citing various passages from his book, we have found that it is in fact this phenomenon upon which all of Tobias Carlisle’s investing theories and strategies are based. Therefore, far more than just a mere theory, it is entirely possible — or indeed probable, given the amount of time and effort that Tobias put into his research — that an appreciation for mean reversion in equity investing will help to improve the performance of one’s portfolio. In conclusion, if there is one investing principle that you choose to incorporate, be it in bull markets or bear markets, let it be the adoption of mean reversion in assessing your portfolio.
* In finance, mean reversion is the assumption that a stock's price will tend to move to the average price over time.
** The Wheel of Fortune, or Rota Fortunae, is a symbol of the capricious nature of Fate. The wheel belongs to the Roman goddess Fortuna (Greek equivalent Tyche) who spins it at random, changing the positions of those on the wheel — some suffer great misfortune, while others gain windfalls.
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