“This book is a short, simple explanation of one of the most powerful ideas in investing: zig."
“Zig?"
“Zig when the crowd zags. Zig with the value investors. Zig with the contrarians.”
With those words, Tobias Carlisle began his 2017 book, “The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market.”
Carlisle is a corporate lawyer as well as the founder and managing director of Acquirers Funds and the author of several books on investing. Based in Australia, he specializes in acquisitions and mergers and has advised on deals in multiple countries, including the United States and the United Kingdom.
Among the billionaires referenced in the book, the big names included the young Warren Buffett (Trades, Portfolio) as well as Carl Icahn (Trades, Portfolio), who was described as an investor who will buy at the very worst time because he thinks the crowd is wrong, and Paul Tudor Jones (Trades, Portfolio), who explained it is time to sell when the markets look their very best and keep making new highs. Another guru on the list was global investor Michael Steinhardt, who wanted four things when he was briefed: (1) the investing idea, (2) the consensus view, (3) the “variant perception” and (4) a trigger event.
Also on the list were Peter Thiel, Ray Dalio (Trades, Portfolio), Howard Marks (Trades, Portfolio) and Seth Klarman (Trades, Portfolio).
In the book’s preface, Carlisle began by introducing zig and mean reversion, “the idea that things go back toward normal.”
Zig refers to the idea that contrarians zig when most of the market zags. In other words, they buy at good prices because the crowd wants to sell, and sell when the crowd wants to buy. Often, low prices mean something is seriously wrong with the company and stock, so why would we buy them? Because of mean reversion.
Mean reversion means low-priced stocks get more expensive and expensive stocks get cheaper over time. The crowd zags, expecting a trend to continue forever, but deep-value investors and contrarians zig, expecting trends to change sooner rather than later.
Carlisle added that because of mean reversion, not only do out-of-favor stocks often beat the market, but also that fast-growing businesses tend to slow down, while profitable businesses become less profitable. He offered this visualization of mean reversion:
Buffett began his illustrious investing career by buying cheap stocks based on the ideas of his mentor, Benjamin Graham. Buffett called them “cigar-butt” stocks, based on the theoretical idea that most cigar butts still have a puff or two in them when they are thrown away. He also called them “fair companies at wonderful prices.”
Later, and influenced by Charlie Munger (Trades, Portfolio), Buffett changed his focus to buying the highest-quality companies at reasonable prices, which he referred to as “wonderful companies at fair prices.” In 2006, guru Joel Greenblatt (Trades, Portfolio) published “The Little Book That Beats the Market,” which confirmed great companies at fair prices beat the market.
Carlisle wrote he ran his own test based on Greenblatt's, arriving at the same conclusion. But he also found that buying fair companies at wonderful prices—Graham and Buffett’s original strategy—did even better.
Rhetorically, Carlisle asked why an investor would buy a failing business, even if it is undervalued. He offered three reasons:
- There may be valuable assets, such as cash, that the crowd misses while rushing to the exits.
- Some businesses that appear to be “scary, bad, or boring businesses” may turn not be quite so scary, bad or boring.
- Poorly managed businesses may attract outside investors, private equity firms or activists that want to turn them around.
As the author wrote, these reasons open opportunities for “contrarians with calculators.” Mean reversion, he wrote, is the expected outcome, but the crowd finds a trend and extrapolates it, as if expecting the trend to last forever.
Mean reversion occurs because of competition and because entrepreneurs and other businesses see fast growth and high profits as an opportunity too. And so that stock that was solidly trending upward attracts strong competition and is brought down, with its share price becoming undervalued.
That undervaluation attracts value investors and fundamental investors, who see one or more of the three reasons listed above. In addition, as the stock price falls, they see the emergence and perhaps growth of a margin of safety. That’s important because, “The bigger the margin of safety, the better the return.”
Carlisle reminded readers that it takes two to make a trade. Speculative investors see their extrapolation fail and want to get out of the stock badly enough to offer their shares at bargain prices. Value investors are willing to help and will gladly buy those shares once they fall to a certain level.
In the final section of chapter one, Carlisle moved on to what will be his controversial position: That Buffett’s original, cigar-butt strategy outperforms his later, Munger-influenced strategy of buying companies with sustained high profits. In other words, from “fair companies at wonderful prices” to “wonderful companies at fair prices.”
For “The Little Book That Beats the Market,” Greenblatt tested Buffett’s “wonderful companies at fair prices” strategy—what he called the “Magic Formula.” Greenblatt found that the Magic Formula did outperform the market.
Carlisle came to the same conclusion after repeating Greenblatt’s testing, and then created a new test in which he and his associates bought “the most undervalued stocks with no regard for profitability.” They discovered their “fair companies at wonderful prices” beat both the Magic Formula and the S&P 500. They called the “fair companies at wonderful prices” the “Acquirer’s Multiple.” Next, they set up a contest between early Buffett and later Buffett. Carlisle provided this chart of the outcomes:
Why did the Acquirer’s Multiple outperform the Magic Formula? Carlisle had two answers:
- “It seems the size of the margin of safety—the price discount from value—is more important than profitability.”
- “High profits are mean reverting, and falling profits dampen the returns to the Magic Formula.”
So billionaire contrarians (other than the mature Buffett) zig by emphasizing the margin of safety rather than profitability because profitability is sensitive to mean reversion.
Notes
Carlisle responded to what would no doubt be an obvious question: Was Buffett wrong about choosing “wonderful companies at fair prices”? Carlisle said, “No,” referring to Buffett’s preference for stocks with sustainable profits, protected by a moat or competitive advantage.
Another way to look at this contest of strategies is to think of capital gains (Acquirer’s Multiple) versus compounding plus more modest capital gains (Magic Formula).
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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