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Deep value investing takes advantage of mean reversion: that prices eventually move back toward normal.
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To beat the market, you can’t invest with the crowd. You must invest differently than the crowd and be right.
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Deep value stocks have a built-in margin of safety. The stocks are undervalued because the possibility of a worst-case scenario is already priced in. That gives it a high upside/low downside bet. The worst-case scenario provides a low downside, so you can’t lose much if you’re wrong. But if you’re right, the high upside brings exceptional returns. So even if you’re right as often as you’re wrong, you do okay. Be more right than wrong, you do great.
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Why buy an undervalued failing business? Because of 3 opportunities:
- Its assets have value. The crowd might be selling because of the poor business while ignoring the assets.
- The horrible news surrounding the business turns out to be less bad. With the worst-case scenario off the table, the stock price adjusts higher. (Also, the crowd can overreact by discounting the worst-case scenario. So realizing the worst-case scenario leads to a good return.)
- Activists and private equity seek out poorly managed businesses to be bought out/turned around.
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Competition is behind mean reversion. High profits attract competitors, competition eats into the profits and growth, losses cause competitors to fold, which allows for high profits for survivors. It’s a relentless cycle.
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The byproduct of mean reversion is undervalued stocks beat the market, expensive stocks fall short. High-growth businesses slow down. High-profit businesses see profits fall. Declining companies turn around. Unprofitable businesses become profitable.
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A few businesses have sustainably high profits (moats), but finding them are difficult:
- Businesses with moats are rare — rarer than the crowd expects. Confusing peak business cycle for a moat is a common mistake.
- Moats don’t guarantee high profits.
- Moats don’t last forever.
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Buffett was closer to a deep value investor during his early partnership days, before transitioning to a “wonderful companies at fair prices” investor. See’s Candies, with its high return on capital, was the catalyst. Dollars reinvested into a business with a high sustainable growth rate, compounds the value of the business over time. A rare company like See’s has a moat that fends off mean reversion.
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The risk of following Buffett is being a poor judge of moats. It’s difficult to tell the difference between an average business at the top of its cycle from a wonderful business…until mean reversion kicks in.
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The Acquirer’s Multiple attempts to avoid that risk by buying “fair companies at wonderful prices” (unlike Joel Greenblatt’s Magic Formula, which attempts to replicate Buffett’s “wonderful companies at a fair price” strategy).
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The Acquirer’s Multiple compares the total cost of a business (if you were to buy it outright) to its operating income or enterprise value divided by operating earnings.
- Enterprise Value = market cap plus debt plus preferred stock plus minority interest minus cash.
- Operating Earnings = revenue minus the cost of goods sold minus administrative costs minus depreciation/amortization.
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A negative EV, in theory, is a good thing — low/no debt with lots of cash. But it’s likely a sign of a bad business that burns through cash.
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Using OE makes for easier apples-to-apples comparisons across companies. It takes a top-down approach to the income statement, by including interest and taxes and excluding any one-off special items (non-recurring income) that can inflate/deflate reported earnings.
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Backtesting shows The Acquirer’s Multiple beats the Magic Formula and the S&P500 in from 1972 to 2017. It crushed an opposing strategy that buys a basket of stocks with the highest profits (the high profits strategy actually beat the S&P 500 too).
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Margin of Safety:
- Allows room for investor error. The deeper the discount to fair value, the bigger the margin of safety, the more room for error, the better the potential return, and the lower the risk.
- Ex: margin of safety on balance sheet — low debt in relation to cash or size of the business. Excessive debt may lead to financial distress.
- Ex: margin of safety in business — real business with a history of real earnings and cash flows, with no signs of fraud or earnings manipulation.
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De Bondt and Thaler (1987) study tested mean reversion on profits. Profit growth on undervalued stocks rose higher than expansive stocks (profit growth actually slowed on expensive stocks). And undervalued stocks beat the market by 41% over 4 years, while the market beat expensive stocks by 1%.
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Two Value Investing Rules:
- Undervalued stocks beat expensive stocks and the market because stock prices mean revert.
- ROE and earnings growth rates mean revert too.
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Concentrated Portfolio Trade-off:
- Higher Volatility — more volatile than the stock market.
- Higher Tracking Error — less likely to track the market.
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Simple rules beat the experts and the amateurs. Investors who follow a strict set of rules may override the rules to their own detriment. They tend to find a lot of “broken legs” — reasons to avoid a stock the rules would otherwise include — in irrelevant data.
Quotes
“Mean reversion is the expected outcome. But we don’t expect mean reversion. Instead, our instinct is to find a trend and extrapolate it. We think it will always be winter for some stocks and summer for others. Instead, fall follows summer, and spring follows winter. Eventually.”
“Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” — Jeremy Grantham
“The most surprising result of Buffett’s theory of value. Not all growth is good. Only businesses earning profits better than the rate required by the market should grow. Businesses with profits below that rate turn dollars in earnings into cents on the dollar in business value. The owner of the good business wants the business to reinvest and grow because that growth is profitable. The owner of the bad business wants all the earnings paid out because the growth destroys value. Alas, good business can’t absorb much extra capital without profits going down. And bad businesses need all earnings reinvested just to keep up with inflation. For a business to be worth more than its invested capital, it must maintain a profit greater than the market requires.”
The key to maximizing returns is to maximize our chance at mean reversion. That means maximizing the margin of safety. We want the most undervalued stocks. And we want to make sure they survive to mean revert.
Activists focus on excess cash because too much can hurt a company’s value.