Investors Are Reversion Hunters, Not Trend Chasers
Some thoughts about the nature of the investment returns.
What type of activity is investing?
Is it quantitative, artistic, scientific, conditional, or repetitive?
I don’t think there is an easy answer to this.
What’s obvious is that it includes elements from all above. It’s quantitative, but you don’t need calculus; 8th-grade math would be enough. It’s artistic because numbers don’t guarantee results as in math or physics. It’s repetitive because you have to repeat what works, but there is no guarantee that what once worked will work; in that sense, it’s also conditional.
Success depends on bringing those elements together at the right ratios, and at the right time and conditions. And then, you have to think independently and bet on the direction your own research shows.
Counting all these, I think investing is a highly intellectual activity.
Look at all the successful investors and you’ll see that they are intellectuals.
They come from a wide range of backgrounds. Charlie Munger studied Law, Chuck Akre was an English major, Peter Lynch studied History, Bill Ackman majored in Social Studies, Michael Mauboussin studied Government in Georgetown, etc…
Regardless of their background, intellectual depth is their common property.
Look at their writings, podcasts, and interviews, and you’ll see that they talk more like philosophers thinking about business value. They talk about what drives returns, how the humans and the market behave, what determines durability, etc..
On the other hand, look at the writings of market-driven fund managers of Wall Street, and the intellectual depth will be like—“it’s a buy, the sucker is going up.”
As manifested by their long-term performance, intellectual depth pays up.
This is why we have tried to ruminate on the nitty-gritty of investing as often as possible. I would say these have been the fundamental factors that distinguish our work and our community from others out there.
Today, I want to take this issue as an opportunity to discuss an important aspect of investing that I think is being increasingly ignored recently in the market euphoria.
The subject is simple—where does investment value come from?
What led to the urge to discuss this was a comment below one of my Tweets saying that UnitedHealth was at an attractive valuation:
What perplexed me was the last sentence—“there are easier places to make money right now.”
Easier places to make money? Then I looked at the comments I saw many people saying similar things:
Why buy this shit instead of Microsoft?
Nvidia only goes up; this only goes down.
Don’t fight the trend, invest with the trend.
Let me be straight—this is some grave misunderstanding of investment returns.
You don’t even need to think deeply about it. There are already thousands of people on Wall Street who try these, and they are very, very smart people. Yet, 95% of the hedge funds still underperform the market in the long term.
Meanwhile, Buffett just sits there with his boring stocks and quietly outperforms the market for the last 60 years.
What’s even more perplexing than this is that he has missed literally all the banger stocks of the last 6 decades—Microsoft, Amazon, Nvidia, Google.
He didn’t even own Apple until 2016.
So, if he crushed the markets despite missing all the trends, where do the investment returns come from?
To understand this, we should understand two things first:
What’s the return?
How do you generate it?
The first question is intuitive—return is the difference between value and price.
That leads to a deeper question?
What’s the value of an investment vehicle?
This also has a definitive answer in the finance literature. Value is the sum of cash flows that an asset will generate in the future, discounted to the current day.
In other words, value is the manifestation of the earning power of the business.
All the assets it has, human capital and know-how, create its earning power, and this way they are reflected in the valuation.
This is why, for equity valuation, earning power is what singlehandedly drives valuation. Individual assets aren’t important; they are reflected in the earning power.
We can easily observe this by looking at the poor returns of investors who are investing based on the asset value of the business.
There are a lot of them on Twitter, and especially on Substack. They often find businesses that they think have hidden assets that, when summed, are valued more than the business itself. They often present these as hidden opportunities.
Yet, such a strategy works poorly in practice.
It’s because what’s important is the earning power, not asset value.
The business makes no money, but it has a hospital building that is estimated to be worth $100 million in the market. More than 80% of the stock is owned by insiders, a family that has no interest in selling their shares (for some reason).
What’s the company worth to a public market investor? At least $100 million, right?
It’s worth way less than $100 million.
For an investor who can’t liquidate the company, the asset isn’t important, and obviously, there is no earning power in the business. At this stage, any price would be for the probability of management’s making a productive use of the asset in the future. That would be priced like an option, so the business would be valued way lower than $100 million.
Even if there is a possibility of liquidation, I argue that the valuation would be way lower.
Benjamin Graham explains this squarely in Security Analysis:
Specialized assets take the full market value only in their specific domains. A hospital building would be way less appealing to buyers other than hospitals. If there are no hospital buyers, it’ll be sold at a deep discount.
Warren Buffett gives an example of this in his 1985 letter to Berkshire Shareholders:
Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980 to 1984, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30 to $50 million.
Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.
Warren Buffett, 1985 Berkshire Hathaway Annual Shareholder Letter
Thus, investment value almost exclusively comes from the business’s earning power, which is the sum of today’s and future earnings.
This is the conclusive answer to the first issue of investing. Now, let’s get on to the second issue—how do you generate returns?
It starts with estimating the value.
Millions of smart people in the market try to estimate the future earnings of a business and make their bids. This way, the business gets priced in the market. This is why the underlying assumption is that the market price reflects all knowable things about the business because millions of smart people would discover all the knowable things.
To generate a return, an investor should catch a disconnect between the price and value.
Given how the securities are priced in the market, there are only a few sources for this disconnect:
➡️ Consensus doesn’t fully comprehend the value.
This is improbable given that the price is assumed to reflect all knowable things. There may be unknowable things that an investor may successfully forecast by their pure vision, but it’ll be more speculative than dependable.
➡️ Value increases due to an unpredictable event.
This is what we discussed above. COVID, for instance, led to an increase in the value of carriers like UPS and FedEx, but it was an unpredictable event. Making decisions based on unpredictable events isn’t investing.
➡️ Asset becomes more popular without any change in fundamentals.
In this case, the price is driven by the expectation that there’ll be people who will be willing to pay more. It’s almost always impossible to forecast when this train stops.
➡️ Current market price is too low for the current value of the asset.
This is the source of of disconnect that an investor can dependably spot using the tools and information available to him.
When the price is too far away from the value in both directions, it’s only a matter of time before somebody screams—the King has no clothes!
This is because there are millions of smart people looking for these disconnects in the market. When it happens, that gets the attention of other smart people, and they join the act too.
This is why the real value has some sort of magnetic pull that results in swings in price to the opposite direction when the price is far too ahead in one direction.
What’s the side effect of this?
Once triggered, the swing rarely stops at the real value.
Think of it like a literal pendulum swing.
It goes to one maximum and reverses, but it doesn’t stop at the equilibrium point; it goes to another maximum, and it repeats this over and over again.
The crucial fact is that it crosses the equilibrium point each time.
You may not know exactly where the equilibrium point is, but at the maxima, you can say which way the pendulum will move next, as you know the mean reversion is the strongest at around the maxima.
Stocks move the same way.
You don’t know exactly where the fair value is, but at the extremes, you can say the direction of the future movement.
Look at Microsoft’s P/E chart:
Microsoft’s average P/E in the last 5 years was 33.
Looking at the chart, it’s somehow hard to say what the return will be at 34 or 32 P/E, but it’s way easier to say the return won’t be high at 38 times earnings, or conversely, it’ll be high at 23 times earnings.
This is why I think investors are reversion hunters rather than trend chasers.
This is clearly illustrated by Warren Buffett’s Apple investment.
When he got into Apple in 2016, the stock was trading at just 10 times earnings, while the median P/E for the previous decade was around 14.
We all know how well that worked out.
This clearly illustrates that betting against the trend is the norm, not the exception, for outsized returns.
Riding the trend may provide you with a false sense of security, but unless the exit is timely, all the gains are erased in mean reversion. And getting the exits timely all the time is impossible.
Instead, betting against the trend and for the mean reversion at both maxima, when supported by fundamental research, works more dependably.
This is why I think people are wrong when they think investing in something on an uptrend is safer. Sure, it gives you peace of mind and a sense of security as everybody is doing it. Yet, if you can’t time the exit, you become others’ exit liquidity.
In no way is the market going to give you money more easily.
Chasing the trend is easier on the mind but extremely hard to practice. Betting on the opposite direction at extremes is quantitatively easier, but it’s psychologically very hard. It requires:
Independent thinking.
Emotional discipline.
Contrarian streak.
Still, once you build these qualities, the reversion strategy is more dependable.
🏁 Conclusion
Whenever I take a contrarian position, I get the same reaction—there are easier plays.
There is not.
What they deem as an easier path has been tried and is being tried by thousands of smart people on Wall Street under the name of “momentum investment.”
Result? Most of the hedge funds still underperform their benchmark in the long term.
If you want outsized returns, you have to internalize that you are basically trying to benefit from the gap between the value and price.
This gap is where all the investment returns come from; there is nothing else.
There are only a few sources of this gap, and most of them cannot be dependably predicted; they are too sporadic. Only one of them, the gap between the price and the current value, can be more reliably detected.
In this case, the value is the current earning power and the earning power of the business in the near future.
Make no mistake, the market doesn’t generally get this wrong, as it’s not too hard to forecast the near future. What it gets wrong is the multiple most of the time. Two things affect the multiples most:
Emotion
Durability of earnings
Emotion is also largely driven by the perception of durability, so we can say that the perception of the durability of earnings and the durability of the growth in earnings is what drives multiples in the short term.
So, a long investor’s job is pretty simple:
Find prospects that are close to the bottom end of their valuation.
Ask whether the earnings could be more durable than the multiple implies.
If the answer is yes, you make the bet.
If you are right, mean reversion will come, and you’ll have a high initial return, and most of your return will come from multiple expansion.
However, that initial return will determine your long-term average return.
Assume a 10% annual market return. If you get 30% return on your investment in the first year and just 10% in the next 4 years, your average annual return in the 5-year period is nearly 14%. In relative terms, you are performing 40% better than the market.
This is why I think successful investors are reversion hunters, not trend chasers.
Hope this sparks some deep thinking.
Great points. I'm not an expert in this by any means. But I believe in the 4th industrial revolution, AI, and all it's connected pieces. Robots, data centers, energy, nuclear, rare earths. I believe there is a good chance all those sector will be higher years from now. That's the only advantage I have as an investor. Can't just jump at every new thing.