"What goes up must come down" is an everyday expression which explains the statistical concept, reversion to the mean. Most statistical theories or investment models are very complex and have limited successful track records, but reversion to the mean is intuitive and easy to grasp.
Most important, reversion to the mean is the basis of value investing. Many well-known and successful investors, including Benjamin Graham, David Dodd, Warren Buffett and Seth Klarman, are value investors. These investors use reversion to the mean as an investment philosophy to guide them to buy certain companies. By exploiting time arbitrage, a fancy term meaning one has a long-term time horizon and can weather short-term fluctuations, investors can make money by buying undervalued stocks and waiting for them to return to their historical valuations - to revert to the mean. An easy to understand example illustrates this basic philosophy.
Imagine that company XYZ has traded throughout the past five years at an average multiple of 18 times earnings. This means that the stock price divided by earnings per share - the company's net income divided by common stock shares - has equaled 18. Now, the company trades at 12 times earnings. We can see that the lower multiple, 12 compared to 18, means that the price for a share of stock has decreased in relation to the profitability of the company. Clearly, something in the market has occurred to cause shares to dip and reach a lower valuation. Perhaps a top manager such as the CEO or CFO suddenly resigned, or the company had to deal with a product recall or fell short of Wall Street's earnings expectations. But if the investor sees no secular, long-term changes in company XYZ, this dip in share price and valuation creates a great buying opportunity because the stock should eventually revert to the mean and trade at its historical 18 times earnings.
Not only are individual stocks subject to reversion to the mean but also entire stock indices. Global debt worries and weak economic indicators have shaken markets around the globe. Currently, the S&P 500, a collection of 500 significant enterprises, trades at 13 times earnings, meaning the price of the index divided by the earnings of the 500 companies equals 13. The long-term average price to earnings for the S&P 500 since 1960 is about 16. Therefore, we can see that on a historical basis, the S&P 500 is undervalued. To capitalize on the coming reversion to the mean when equity prices rise in relation to the earnings power, investors can buy exchange traded funds which track the performance of the S&P or even buy call options.
But of course, if capitalizing on reversion to the mean always worked out in financial markets, we would all be rich by buying undervalued securities and waiting for them to reach their historical valuations. Reversion to the mean doesn't always occur, which is what keeps the game interesting.
Value traps are a key reason why reversion to the mean sometimes fails. The term value trap refers to stocks with discounted valuations which are not as attractive as they seem. Investors are drawn to these stocks, but the chosen company might have fundamental, structural flaws which explain the discount. Furthermore, when the stock price goes down, it becomes cheaper and cheaper to buy, making it seem more attractive despite its fundamental flaws. Even if the stock remains at a constant price, one is still losing money because inflation and the opportunity cost of the investment are eating away at one's capital. Value traps are the reason why simple reversion to the mean strategies don't always work as intended, and since we're human, we fall for them.
Sometimes when a major company faces bankruptcy, a large intuitional investor tries to cheaply take control of the distressed company in hopes of reviving it. Veteran investor Carl Icahn, who was active in the 1980s M&A scene, fell victim to the value trap with Blockbuster. The Street reports that Icahn bought many shares of Blockbuster in 2004 when Blockbuster had already fallen over 20 percent from its 2002 range. So it's no surprise that when Blockbuster became even cheaper to buy, Mr. Icahn also bought one third of its debt. Now that Blockbuster is totally bankrupt, Icahn wrote in an article for the Harvard Business Review that, "Blockbuster turned out to be the worst investment I ever made."
Renowned financial writer Jim Grant of Grant's Interest Rate Observer learned this lesson when he started a fund and invested in undervalued Japanese stocks. After the Japanese real estate bubble popped in the late 1980s, Japan was mired in years of stagnant economic growth and deflation. Despite the national woes of the country, Japanese equities were dirt cheap on a valuation basis, so investing in Japanese companies should have been a no-brainer. Yet, the stocks never increased in value - as Grant revealed in a Wall Street Journal interview, "These bargains can and did remain bargains for 12 years." Japan's Nikkei Stock index has been in overall decline since 1989.
Overall, investing by reversion to the mean is a proven strategy. But it's important to understand company risk and accept losing some money here and there to cut losses and avoid getting stuck in the value traps.
Harrison's column runs biweekly Wednesdays. He can be reached at h.freund@cavalierdaily.com.
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