Unconventional wisdom: Five ASX candidates for a mean reversion strategy
A sensible way to pursue a mean reversion strategy.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Five ASX candidates for a mean reversion strategy
“The market is there to serve you rather than instruct you.”
- Warren Buffett
Professional investors like to talk about ‘smart money’ and ‘dumb money’. Unsurprisingly they are referring to themselves as the ‘smart money’. The ‘dumb money’ is us - the great unwashed individual investors.
The distinction often comes down to the guise of academic inspired professionalism. The professional investors have modern portfolio theory, the efficient frontier, investment committees and sophisticated risk models.
There are rare cases where sophisticated investors excel practicing this type of investing. In many cases more straightforward approaches are dressed up in a cosplay of complexity. And the results…..most professionals fail to beat an index.
Then there is us – the ‘dumb money’. We are free to pursue simplicity without being simplistic. We can choose an informed approach tailored to our personal circumstances without the orthodoxy of adhering to a strict investment style.
Mean reversion often falls in the ‘dumb money’ camp. It is portrayed as an approach akin to a trick and based on the superstition that what goes down will eventually go back up.
Yet this portrayal doesn’t tell the whole story. A deeper exploration of the data shows how mean reversion can be successful and how the ‘dumb money’ can win in the end.
From sweet peas to Mr. Market
A man by the name of Francis Galton came up with the term mean reversion by observing multiple generations of sweet peas. I won’t bore you with the details. The point is he discovered that in the aggregate population of sweet pea seeds the size of the seeds followed a normal distribution.
A normal distribution means that while each variable can be random, on an overall basis they are distributed in a symmetrical bell-shaped pattern. With that fun fact it is time for Galton to exit our story. He took his observation of mean reversion down a dark pathway into the pseudo-science of eugenics – a term he coined. I’m going to try to apply his observation to investing.
That brings us to Ben Graham’s Mr. Market. In his metaphor Graham described Mr. Market as a mostly reliable evaluator of how much a share is worth. Yet sometimes Mr. Market gets overly excited or aggressively pessimistic. It is in the aftermath of these periods of euphoria and gloom that mean reversion comes into play.
Mr. Market is important because despite the way investing is sometimes portrayed it is not scientific. This means we need to be careful about applying a scientific term like mean reversion to the investment world. To do this is to practice another form of pseudo-science by ignoring the fact that introducing the human element to anything muddles the predictability of outcomes.
Do share prices that go down also go back up?
The key to Galton’s theory of mean reversion is that the data is normally distributed. The offspring from a seed whose size put it on the tail end of the distribution would move back towards the middle of the distribution. This is reverting towards the mean.
This doesn’t work in investing because share market returns are not normally distributed. This may all seem like a bunch of academic nonsense. And it is. But bear with me for a minute.
In statistical speak share returns are positively skewed with a long-tail to the right. That is exhibited in the chart below. For reference the mean is the average, the median is the middle value in a data set, and the mode is the most frequent value in a data set.
I promise I’m done with the statistics. Now the fun stuff – how you can use this to get better investment results.
To be positively skewed with a long-tail to the right means that overall share market returns come from a surprisingly small number of shares. To beat the market you need to find these outsized winners.
A wonderfully named professor called Henrick Bessembinder looked at share market returns in the US between 1926 and 2016 and found that 90 shares accounted for half the total return of the share market. All the total wealth was created by 4% of listed companies. That leaves 96% of shares earning a return that matched or underperformed US Treasury Bills which is a proxy for the returns on cash.
This is where all that mean, mode and median stuff comes in. The average return of shares is dragged up by these high-flying shares. Most shares do poorly but we lose sight of this when looking at overall index returns.
If you are picking individual shares in your portfolio and don’t pick the outsized winners you will underperform the index. This is why passive investing is so compelling.
The distribution of returns has implications on a mean reversion strategy. Buying a share just because the price has gone down is no guarantee it will come back. Most shares don’t which is why they underperform.
Researchers Michael Mauboussin and Dan Callahan from Morgan Stanley found that the average share experienced a fall or drawdown of 81%. These are the types of drops an investor following a mean reversion strategy would likely jump on. The issue is that the Morgan Stanley research found that half never regained their previous high.
The Morgan Stanley data did show that the outsize winners that influence overall share market returns – the long-tail to the right – had practically the same drawdown as the average share. In the case of these shares the drawdown was a temporary set-back in an otherwise great outcome.
Applying this research to our own portfolios
Time to pause. We’ve covered sweet peas, statistics and Professor Bessembinder. The data suggests there are two potential ways to profit from a mean reversion strategy.
Go bottom fishing
The data from Morgan Stanley shows that half the shares never regained their previous high after a drawdown and Bessembinder’s research found that 96% of shares don’t generate wealth. This suggests that mean reversion doesn’t work.
Yet the long-term data ignores the impact of buying low. Bottom fishing works if you get the timing right. Consider a share that fell 80% and only recovers half of that loss. It is still 40% below the pre-drawdown price.
The overall long-term return picture on this share is not going to be great. It didn’t recover from the high and likely won’t generate any wealth over the long-term. Yet an investor who purchased the share when it was down 80% and holds until it recovered to 40% below the high still triples their money.
A dead cat bounce can be profitable. The problem is that to execute this strategy means buying lots of shares because there will inevitably be companies that go out of business. You need to make up for those total losses. You also need to get the timing right and buy close to the low since the recovery is limited. I’m putting this in the too hard category.
Try to find the long-term winners at the right time
The interesting part of the data from Morgan Stanley is that long-term winners suffer the same drawdowns as the average share. To really profit you just need to find the shares that not only fully recover but continue to compound over the long-term.
This is clearly the preferred approach but like everything in investing it is easier said than done. One attempt is the Dogs of the Dow strategywhich comes from a book written by Michael B. O’Higgins in 1991.
The Dow Jones Industrial Average (“DJIA”) is a bit of an anachronism. The 30 constituents are picked by a committee and are supposed to represent the most prominent US companies.
The Dogs of the Dow strategy involves buying an equally weighted portfolio of the 10 highest yielding shares in the index and holding them for one year. At the end of that year the portfolio is rebalanced and replacements are made based on the highest yield criteria.
The universe of companies considered is the key to this strategy. The practical application of the DJIA selection criteria is that mature and large companies have been picked that often have a history of strong returns.
To be added to the DJIA means that the shares are likely members of the small minority that drive overall market returns according to Bessembinder’s research.
A high dividend yield is a proxy for shares that have underperformed but doesn’t indicate a share has suffered a large drawdown. This is not a perfect mean reversion strategy.
Even if the Dogs of the Dow strategy identifies great companies that have temporarily run into issues there are problems with this approach. The one year holding period means investors likely aren’t able to take advantage of the full bounceback.
According to the Morgan Stanely research the median share in their data sample took 2.5 years to fully recover from the drawdown – for the roughly 50% of shares that did in fact recover. Patience is one of the biggest advantages for an investor. It is the key to a mean reversion strategy.
Looking at Australian opportunities
I think the Dogs of the Dow is a gimmick that is being used to sell a book. But I do like the inclusion of additional criteria to try and identify which shares are right for a mean reversion strategy.
We don’t have a DJIA in Australia. Instead I’ve used our analyst ratings to find companies that may be candidates for this strategy. I’ve selected the following criteria:
- An Economic Moat Rating of wide or narrow: I want to identify companies that have temporarily fallen on hard times but have the potential to be a long-term outperformer. A company with a moat can fend off competition and prosper over the long-term.
- An Uncertainty Rating of low or medium: Lower business risk means that future outcomes are more predictable. In this case I’m trying to avoid companies where temporary problems might turn into a death spiral.
- Capital Allocation Rating of exemplary or standard: As part of their Capital Allocation rating our analysts look at balance sheet strength. I want a company that has the financial strength to survive whatever issues are causing the share price to drop.
I’ve screened our coverage universe in Australia and the following five companies have the largest one-year loss while meeting my other criteria. Perhaps these are candidates for further research.
Final thoughts
Warren Buffett has often spoken about the need to view the market as a mechanism to serve you rather than inform you. This is the context needed to profit from shares that have dropped significantly in price.
Many investors view a big price drop as an indication that a share should be avoided. In many cases this is true. But for some beaten down shares the market is serving you an opportunity. A sensible mean reversion strategy can be a pathway for success.
Comments? Email me at [email protected]
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Invest Your Way is a personal finance book that combines foundational investing theory, real-world application and our own experiences. It is designed to help readers create a financial plan and investing strategy that is tailored to their unique goals and circumstances.
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What i’ve been eating
My goal was not to repeat restaurants in this section. But Pilu is a worthy exception to my rule. Last Saturday was a beautiful day in Sydney and I had another amazing meal overlooking the ocean and watching the whale migration. Pictured is the largest freshwater fish in Australia – the Murray Cod. The Murray Cod is carnivorous and eats shrimp, yabbies and crays. I think this diet reflects well on the fish as we both enjoy eating the same thing.
