Important Updates for Investors
Carla Pasternak's Premiere Issue of High-Yield International Just
Released
Income expert Carla Pasternak's debut issue of High-Yield
International covers a Taiwanese manufacturer yielding 9.5%... a
rare Mexican monopoly yielding 13.4%... and other top-performing
investments yielding up to 19.0%.
Government's Biofuel Timetable Could Spell +15,900% Growth
+15,900% growth might seem far-fetched... but it's not. In fact, it
is mandated by law. And I've identified the ONLY stock positioned to
capture this growth.
The
Silver Lining to a Falling Dollar
Despite the U.S. national debt, there is a silver lining for income
investors. This massive spending, combined with movement out of U.S.
Treasuries, is going to take its toll on the dollar, and
international income investors could reap the rewards in the form of
higher dividends. |
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| Profiting
from Mean Reversion |
Published: February 21, 2006
As investors,
those who have adopted a value philosophy must feel comfortable going
against the grain. While it sounds relatively simple in theory, it can
actually be quite difficult in practice to buy when it seems that
everyone else is selling -- and vice-versa. However, it is precisely
this contrarian approach that allows us to identify unloved (and
undervalued) stocks that Mr. Market has unfairly beaten up or
overlooked.
Unwittingly, the Roman poet Horace provided an inspirational quote for
value investors, saying:
"Many have been restored that were fallen. And many shall fall that
are now in honor."
It is doubtful that Horace was referring to the stock market, but the
comment is applicable to investing nonetheless. History has taught us
that trends don't last forever -- falling stocks will inevitably
rebound, and rising stocks will eventually falter.
However, most investors seem to disregard this important truism and act
as if the current trend will continue indefinitely. How many times have
we seen novice investors panic and sell after a sharp market correction,
or wait to buy until after a rally has carried stocks to new highs?
Considering that a sell-off often leaves the market underpriced and a
bull market overpriced, the exact opposite strategy would usually be far
more profitable.
The illogical, emotion-based trading of many unsophisticated investors
is exactly why it is important not to follow the crowd -- and why
contrarians often have an edge.
Over the long haul, those who have the faith to buy when the market has
been dropping will ultimately be rewarded. Why? Because equity prices
have a tendency to revert to the mean. Studies have conclusively shown
that when stock prices get overextended to the upside, they eventually
fall back in line. And when they have been pushed sharply below their
long-term averages, they will soon begin to recover.
The research conducted by MIT finance professor Jonathan Lewellen has
given much credibility to the theory of mean reversion. According to
Lewellen's findings, up to 40% of the market's annual returns are
temporary, and will usually reverse within the next 18 months.
Curiously, he also found that a stock's 3 and 5-year trailing returns
are negatively correlated to the subsequent 12 to 18 month period. In
other words, tomorrow's stock prices will often move in the opposite
direction of yesterday's.
This pattern is not a new development. In fact, according to finance
professor and noted author Jeremy Siegel, stocks have consistently
gravitated towards their long-term moving average since 1802. One of the
furthest deviations from the norm occurred during the tech bubble of the
late 1990s, and we all know how powerful that reversion to the mean
proved to be.
However, stock prices do not exactly snap back into place overnight.
They can remain overvalued or undervalued for extended periods of time.
This is fortunate for value investors, as inefficient markets allow us
time to spot opportunities and take action.
How to Identify Beaten-Up Stocks
So what methodology do I use to find undervalued companies trading well
below their intrinsic values? Well, value is not always easy to
identify. If it were, then investors would quickly pile into undervalued
stocks and would drive the shares immediately higher. Therefore, it is
often necessary to look past the headline numbers -- like revenues and
earnings -- and dig deeper into each company's fundamentals.
Regular readers are probably aware that I am often drawn to firms with
strong underlying business models that are suffering from temporary
problems. Such companies often have solid balance sheets, understated
tangible and intangible assets, and a healthy level of gross profits
relative to enterprise value. Often, these companies are engaged in
turnaround efforts or can find ways to cut costs and improve
profitability.
Generally speaking, I take a bottoms-up approach to finding new
investment ideas. That is to say, I am primarily interested in
evaluating stocks on a company-by-company basis and am less concerned
with the direction of the overall economy, interest rates, labor
markets, energy prices, and other macroeconomic variables. Over the long
haul, a company's true value will shine through regardless of these
factors.
It stands to reason that most beaten-up value plays will have a few
flaws, such as legal problems, falling revenues, deteriorating margins,
or customer retention issues -- just to name a few. However, in most
cases, this type of bad news is already priced into the shares. To a
certain extent, investors have low expectations for these companies and
tend to shrug off mediocre results -- and reward any upside surprises.
Usually, I target companies that are trading at a sharp discount to
their industry peers and have a measurable margin of safety. However, as
noted earlier, undervalued companies can remain that way for months, or
even years. Eventually, the market will recognize a company's true value
and assign it a more accurate price tag, but that can take time.
Therefore, it's always nice to find troubled companies that have a
catalyst to improved performance.
It should be pointed out, though, that mean reversion should not be used
as a substitute for due diligence. Yes, many quality companies that have
been oversold will bounce back in time. However, others have serious
issues that warrant the lower price. Here is a checklist of some common
traits I examine to distinguish between the two...
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Make sure that
cash flow from operations is at least keeping pace with net income.
This will ensure that a company is generating quality earnings.
-
While there
are valid reasons why a company might need to tap its cash supply
occasionally, be cautious of those that are quickly burning through
their cash and reporting consistently weaker cash flows.
-
Focus on
companies that have healthy balance sheets and are not saddled with
hefty debt loads. Some leverage is fine, but I prefer companies that
pay down their debt and maintain reasonable debt/asset and liquidity
ratios. This lends more flexibility to the business.
-
Net tangible
assets should at least keep pace with (if not grow faster than)
reported earnings.
-
Look for
companies that efficiently deploy their assets, as measured by
return on assets (ROA) and other related metrics. An improving
revenue/asset figure is also a good sign that shows an ability to
squeeze more sales from existing assets.
-
Watch out for
dilution, which can gradually water down the value of your shares. A
steady increase in the outstanding share count -- whether by a
series of dilutive acquisitions, excessive options, or some other
cause -- should serve as a red flag to investors.
-
If possible,
focus on companies that have a sustainable competitive advantage.
This will ultimately manifest itself in greater market share and
rising profit margins.
-
Invest in
firms that have seasoned, trustworthy management teams. Those with
serious corporate governance issues are not worth your time or
money. Also look for executives that are fairly (but not
excessively) compensated and have a history of recent insider
purchases.
-
Don't ignore
attractive gross profits. If a company can trim expenses, then more
of this money will eventually flow to the bottom line and strengthen
its earnings picture.
Obviously, there
are many other quantitative and qualitative criteria that must be
evaluated. However, if a company that has recently been placed in Wall
Street's garbage bin by shortsighted traders still manages to score well
on this checklist, then odds are excellent that the shares will reverse
course sooner or later. If nothing else, it should at least be
considered a promising candidate that deserves a spot on your radar
screen.
I sincerely hope you've enjoyed today's report on the importance of mean
reversion.
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Important Note: The above article was merely a small excerpt
from a recent issue we sent to subscribers of our premium value
investing service -- Half-Priced
Stocks. The mission of Half-Priced
Stocks is to help our readers identify securities that are
trading at the steepest discount to their intrinsic net worth. In some
cases this discount can reach up to 50% or more, giving savvy value
investors the chance to purchase quality stocks for just pennies on the
dollar. To receive your
copy of our most recent issue of Half-Priced
Stocks, as well as other guidance similar to this twice per
month, you'll need to subscribe to this publication. To learn more,
please visit:
https://web.streetauthority.com/subscribe-hps.asp
Thanks for reading!
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Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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