Why we believe value works over time
The concept of mean reversion is an essential framework for why all value styles produce excess returns. Indeed, the simple assumption that stock market valuations and interest rates will eventually revert back to some long-term norm or mean is at the heart of most perceptions about future investment returns. But this often leads one to arrive at incorrect conclusions about both the path of markets and their eventual valuation levels.
For individual stocks, today's negative news, fundamentals, sentiment or earnings reports drive a stock's price lower, inherently lowering expectations about the future outlook for the company. The opposite effect occurs on the positive side of these information flows, raising expectations about the future. Yet in many cases, such conditions do not persist indefinitely, and reported earnings and returns on capital revert to some more normal mean level. This process occurs with remarkable regularity and/or periodicity.
From a capitalistic/competitive economy perspective, one would expect that excessive returns on capital would attract new capital and compete away such excess returns. Subpar returns on capital would result in capital being shifted away from that business, company or industry, enabling remaining successful participants to raise their returns on capital. Companies with strong brand franchises often extend the duration of excess returns on capital, but it remains a tenuous assumption that this will be the case into perpetuity or even a period of a couple of decades.
From a cyclical perspective, a company's profit, cash flow and return on capital benefit from economic expansions (moving from below trend to above trend profits and profitability) and decline with recessions (moving from above trend to below trend). As investors attempt to identify these trends, they buy or sell according to perspectives about where companies and the financial markets stand in these cycles. The question is: what scenario or regime will we mean revert to? The problem is that regimes are not stationary, and this assumption of non-stationarity of scenarios or regimes is the key element of this analysis.
From a secular perspective, Wall Street analysts display a systemic and systematic positive bias regarding the future profitability and growth potential of companies. Since the sum of these individual forecasts is usually greater than the possible whole, optimistic forecasts and the duration of this optimism cannot be sustained indefinitely (although sometimes longer than we used to think possible). These individual company forecasts, and the valuations tied to them, eventually revert to lower more sustainable means. This positive bias tends to be focused on the highest potential growth companies, leading to a greater opportunity for disappointment among growth rather than value stocks.
From a market liquidity perspective, value investors are often the natural suppliers of liquidity to the market. This is partly due to patience and partly due to timing. Simply put, most value investors tend to buy from distressed/motivated sellers and sell to eager/optimistic buyers.
From a behavioral psychology perspective, the majority of investors are far more comfortable with investing along with the consensus view on stocks than on divergent non-consensus and /or more extreme views. There also exists a cognitive bias on the part of investors as investors find pleasure in owning growth stocks. These are keys to what makes value investing inherently difficult and a disciplined investment process successful — the value investor periodically must be able to go against consensus thinking. The discomfort of typical investors in making such decisions is also the principal reason why (along with trend-following behavior that increases the magnitude and duration of the overshoot relative to the change in underlying fundamentals) investment opportunities always present themselves. Shifts in investor sentiment about a stock's underlying fundamentals from extreme optimism to extreme pessimism repeatedly create significant mean-reversion opportunities.














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Last updated: June 03, 2015

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