In the previous chapter of "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," author Tobias Carlisle used backtesting to show how his deep-value investing technique beat the Magic Formula from Joel Greenblatt (Trades, Portfolio).
It was part of Carlisle’s case for returning to the investing techniques of Benjamin Graham and the young Warren Buffett (Trades, Portfolio), versus the mature Buffett, Charlie Munger (Trades, Portfolio) and Greenblatt. To put it another way, Carlisle reopened the debate that pitted, in Buffett’s words, “wonderful companies at fair prices” against “fair companies at wonderful prices.”
In chapter eight of his book, Carlisle brought in other names to help explain why “wonderful” prices beat “wonderful companies”:
- Michael J. Mauboussin
- Werner De Bondt and Richard Thaler
- Tom Peters and Michelle Clayman
Financial strategist and academic Mauboussin is the author of “The Success Equation,” in which he tried to follow the fortunes of great businesses over time. He found that great businesses did not remain great in the longer run; most only looked great when they were at the top of their business cycles.
Mean reversion was the culprit—highly profitable businesses attract competitors. As those competitors chip away, profitability erodes and the company eventually becomes just average.
Mauboussin tracked 1,000 companies between 2000 and 2010 and ranked them by their economic profitability. Next, they were divided into five groups, with the most profitable in the top group and the least profitable in the bottom group. On average, those in the bottom group were losing money.
The results showed mean reversion at work, with the highly profitable becoming less profitable and the less profitable becoming more profitable. All groups were trending toward average profitability, as shown in this chart by Mauboussin:
Mauboussin acknowledged that a tiny number of stocks did retain their high profitability, but could not explain why, nor could he predict which companies would retain their edge. Carlisle noted Buffett has had that ability to find needles in haystacks and to know which had moats that would protect their high profit levels.
Turning to behavioral economists De Boldt and Thaler, Carlisle titled this section, “Straight-Line Errors.” Working together in the late 1980s, De Boldt and Thaler believed stocks become undervalued or overvalued because investors overreact. Investors draw straight lines through recent profit numbers and extrapolate the trend too far. This chart illustrates the phenomenon:
Investors' expectations stretch too far, and they give too little attention to mean reversion. When earnings are rising, they expect them to keep going up forever, and vice versa.
To test their ideas, De Boldt and Thaler ranked groups of stocks by their price-book ratios. Book value is what remains after a company’s liabilities are subtracted from its assets, and is a measure of the company’s value. Price-book measures how much investors pay for a share of that book value.
The stocks went into five groups, with the cheapest price-book value stocks in the “undervalued” group. In the three years leading up to the “buy” date, their profits had dropped an average of 30%. Those with the highest price-book ratios went into the “expensive” group, and their profits had risen by average of 43% in the preceding three years.
Here’s what happened in the four years after buy day (the preceding three years are shown in the bolded area):
As the chart shows, the profitability of undervalued stocks increased by an average of 24% in the following four years, while the profitability of the expensive stocks slowed to 8% per year (a 35% decline). As Carlisle wrote, “De Bondt and Thaler’s findings are good evidence of mean reversion in profits. Big increases and decreases don’t continue for long.”
The author added, “Undervalued stocks’ prices go up more than the market, too. If we want high profit growth and a stock price that goes up faster than the market, we should look at undervalued stocks.”
Finally, Carlisle turned to Peters and Clayman. Peters’ name may be familiar; he was the author of the sensational, best-selling book “In Search of Excellence.” Published in 1982, Peters was on a quest to figure out why some companies were excellent, with high profitability and growth. Out of that came eight management principles that made the 43 companies profiled so successful.
But Peters and those successful companies also became the victims of reversion to the mean. Five years after publication of the book, analyst Clayman took a retrospective look at those “excellent” companies. She found they were no longer high flyers; using Peters’ own rules, most of those 43 stocks no longer would qualify as excellent companies.
In a 1987 article for the Financial Analysts Journal, she wrote, “In the world of finance, researchers have shown that returns on equity to revert to the mean. Economic theory suggests that markets that offer high returns will attract new entrants, who will gradually drive returns down to general market levels.” She also created her own portfolio of “unexcellent” stocks to compare with a new portfolio of stocks based on Peters’ criteria.
She found her portfolio of fair companies outperformed Peters’ wonderful companies. In a 2013 experiment, Barry B. Bannister replicated her testing, using data from 1972 to 2013, and reached the same conclusions. He found the unexcellent stocks averaged returns of 14% per year, while the excellent stocks averaged 10%; the excellent stocks actually underperformed the market, which averaged 11% over the same period.
Carlisle proposed two rules for good value investing:
- “Over time, undervalued stocks beat expensive stocks and the market” because of mean reversion.
- “Return on equity and earnings growth rates mean revert, too.”
He added that Buffett obviously has known these rules and has been careful to buy companies with excellent moats.
But Carlisle’s interest was focused more on the young Buffett and “fair companies at wonderful prices” than on the more mature Buffett and “wonderful companies at a fair price.” In coming chapters, he promised to tell readers about other guru investors who also embraced deep-value investing, starting with Carl Icahn (Trades, Portfolio).
(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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