Reblog: Mean Reversion and the Bell Curve

The pressure to outperform all the time leads stock pickers to constantly seek mean reversion trades

Over a three-year time period, stock prices tend to mean revert. This has spawned numerous investment approaches that try to squeeze capital gains out of those reversions. Classic deep value investing, as popularised by Benjamin Graham at Columbia Business School, taught that you would succeed by buying 50-cent dollars and selling them when and if they reverted to the mean. The “Dogs of the Dow” strategy of buying the 10 highest-yielding Dow stocks was born out of mean reversion.

Over long time periods, common stock performance falls on a bell curve like the one listed below. Half the stocks outperform and half underperform. Among the poorest performers, some go to 0%, and 5% of common stocks do so poorly that they can ruin a concentrated stock portfolio. (1)

1Source: empxtrack (https://empxtrack.com/blog/bell-curve-for-performance-appraisal/)

On the other hand, 5% of the winners make enough money in a concentrated portfolio over 20 years to cover numerous 20% to 40% losses along the way. The Bible states that love covers a multitude of sins. In a 25-stock portfolio, a stock that goes up tenfold in 20 years covers quite a few 20% to 40% duds. What do you have to do to avoid big losers, let mean reversion be your friend and allow time to gain the most advantage out of the bell curve?

First, you must stick to quality companies in an attempt to avoid total disasters. In our case, we require a long history of profitability, consistent free cash flow, wide moats and strong balance sheets. Every business goes through rough periods, but if you have a strong balance sheet and sustainably consistent free cash flow, those periods are survivable.

Second, you must constantly ask the question, “Where am I wrong?” Everyone makes stock-picking mistakes, but all the stocks that go to zero had to drop 40% first. Pulling your weeds is the hardest thing to do in portfolio management, but it is amazing how you get rewarded over the following years by leaving more capital to long-duration winners and planting new seeds. Like everyone else, we said goodbye to quite a few companies in 2008. We were rewarded in 2009-2014 by the quality of the remaining list and the new things we bought with the proceeds of selling poor performers.

Third, mean reversion works, and valuation matters dearly. Combining quality with bargain prices is what our whole portfolio management discipline is built on. All the academic studies (Fama/French, Bauman/Conover/Miller, David Dreman (Trades, Portfolio), Francis Nicholson, etc.) prove that the cheapest stocks outperform the average and expensive stocks. There are no guarantees, but here is how relatively undervalued a few of our stocks are as compared to the stock market over the last 20 years: (2)

It appears to us that many health care companies are prepared to revert to the mean in a positive way in the next three years. To gain the most benefit out of mean reversion, you must buy quality companies in industries that are deep in the doghouse. The psychology of holding out-of-favor securities while other investors are rocking and rolling (like in 2016) is what stops most market participants from gaining the three- to five-year reversion alpha.

Fourth, enjoying the benefit of the bell curve has two components. Mathematically, in a 25-stock portfolio, your biggest 20-year returns will come from five stocks. If you sell much of your biggest winners, you reduce the possibility of covering a multitude of 20% to 40% losses on the poor performers. We use the term “maniacal pricing.” We only sell winning stocks when their share prices get very high in relation to the history of the company. This could be 20 price-earnings (P/E) ratio on a bank or 35 times earnings on Starbucks. Our decades of experience in the U.S. stock market help us to understand when the temperature of a Standard & Poor’s 500 company gets maniacally high.

The second component is the cost savings you get by holding your winners to a fault. Low portfolio turnover is the ideal ingredient to add to high quality bargain stocks. The most recent study of U.S. large-cap equity funds showed that turnover averaged 62% and cost the portfolios involved around 80 to 85 basis points (0.80% to 0.85%) on average per year. If you back that out of portfolio results, it means a majority of stock pickers outpicked the S&P 500 Index. As a side benefit, low turnover also keeps the tax man from visiting your stock portfolio as much as those who turn their portfolios much faster.

The pressure to outperform all of the time leads stock pickers to constantly seek mean reversion trades. It is our opinion that the extremely unusual success that Warren Buffett (Trades, Portfolio) had at Berkshire Hathaway is tied to the fact that he took advantage of mean reversion only in companies that fit his favourite holding period, forever.

The great investor, Michael Price (Trades, Portfolio), said, “The fewer decisions I make, the smarter I am.” At Smead Capital, we spend our time wondering where we are wrong, looking for quality companies to buy for mean reversion and holding existing winners that are not maniacal. We’d like to think that 2017 will be a year where practising our discipline will lead to three- to five-year rewards.

(1) Source: empxtrack (https://empxtrack.com/blog/bell-curve-for-performance-appraisal/)

(2) Source: Bloomberg

The original article appears on the website of Smead Capital Management and is available here.

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