Wednesday, September 07, 2011

Reversion to the mean

“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.

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