Mean reversion is a financial term for the assumption that a stock’s price will tend to move to the average price over time (Wikipedia). There are studies that suggest buying stocks below historical P/E or P/B ratios have delivered good results over time. The explanation for this, is mean reversion.
Beware of Simple Formulas
Once the philosophy of buying businesses for less than their value has taken over your mind, a common mistake is to go looking for low P/E or P/B stocks solely. Then, you might be tempted to rely on the mean reversion of the stock to its historical average multiple. Low multiples on earnings or book value may be a starting point, but you should never buy on these merits alone.
A cheap stock is always cheap for a reason. Most commonly the company didn’t live up to the street’s expectations, the industry is out of favor, and the future outlook is pessimistic. The key is to figure out if the situation is permanent or temporary. Low earnings or book multiples will not give the answer.
Mental Shortcuts
Let’s face it: Thinking is hard work, which is why we avoid it. The economists Kahneman and Tversky are famous for their models “System 1” and “System 2” thinking. Simply put, System 1 is your fast, intuitive decision making. e.g. stopping at a red light, washing the dishes. What you do automatically without much thought. System 2, on the other hand, is when you’re evaluating a decision and its potential consequences. The danger lies in your mind inserting System 1 into System 2.
As humans, we are constantly looking for the greatest gain for the least amount of effort. This is natural, and is the root reason for all modern marvels and comforts of the developed world. As we get comfortable, humans are willing to outsource their thinking in exchange for money. A product or service that eases decision making will always be in demand.
If you have chosen the path of an individual investor, you must resist your natural tendencies of looking for mental shortcuts. Of course this is not easy, but it’s not as bad as you think.
The key to overcoming your natural mental laziness, is practicing extreme patience in your investing. The pitcher will throw companies towards you at constantly changing prices. The best part is that you don’t have to swing at any of these. Only swing if it meets your criteria, and especially the punch card.
Mean Reversion In Retail – A Minefield
Investing in retail is tempting to the aspiring investor. We all visit stores and understand them at a basic level. However, e-commerce has changed the industry permanently, and it’s extremely difficult for companies to maintain a durable competitive advantage. To conclude this post, I’ll give an example of a mistake from my own investing journey.
A personal mistake of mine, and thus lesson learned, is investing a few years ago into a retailer that was quantitatively cheap, but a fundamentally broken company. Initially I was attracted to the low valuation, and got blindsided on the qualitative aspect. Some red flags I ignored were:
- Top management had been a revolving door. Most CEO tenures were less than two years. This means that there’s probably something wrong in the underlying business economics.
- Top management had outrageous salaries despite the company’s recent poor performance. Additionally, the proxy statements gave no indication of aligning management’s interests with shareholders.
- The “Moat” was actually not a moat. It was a business model, which at the end did not have anything to protect it.
Despite the company having no debt when i took my initial position, they started leveraging about a year after I bought it. I’ll be surprised if the company survives the ongoing pandemic. Despite losing on this one, I’m glad I invested. The lessons learned were crucial, and thankfully I didn’t bet the farm. Do not adhere to historical averages alone, and only invest in businesses you are comfortable to value.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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