• Markets and insights
  • Investing strategies

Investing strategies

In this monthly series, our experts examine a range of common investor biases and practical ways of overcoming them. Perhaps if we know the biases that we are prone to as investors, we can avoid them in the future.

  

Mean reversion and investing

BY NICK ARMET, 2 APRIL 2014

Mean reversion is a powerful investment concept – it sets up the conditions for investors to take a contrarian approach.

Regression to the mean is a technical term for things evening out from extremes. Primarily associated with statistics, the concept was first popularised by Sir Francis Galton in the late 19th century based on his work on genetics and hereditary stature.

A good analogy that helps to explain the mean regression concept relates to medical intervention. When people get unwell they seek medical attention when conditions are typically at their worst and most then get better. Their recovery is invariably ascribed to the medical intervention, but would they have recovered anyway? In pharmaceutical trials, such effects are compensated by the inclusion of placebo control groups.

Now consider the experienced golfer who is a solid 10 handicapper. When he has a very bad round that is way over his handicap, he books an hour with the pro and improves next time. But did the pro really help or is this simply another case of reversion to the mean? The very bad round was bound to be followed by one closer to his handicap, yet the fact he went to the pro remains persuasive to him.

Mean regression is a difficult concept for the human mind to grasp: our pattern-seeking brains are strongly biased towards causal explanations.

In investment, regression to the mean is referred to as mean reversion and it has a slightly different meaning. It describes how returns can be extreme in the short run but more stable in the long run. To put it another way, periods of lower returns in certain markets or sectors tend to be systematically followed by compensating periods of higher returns.

This is a powerful idea. We know that shifts in investor sentiment can cause market sectors and stocks to become loved or unloved – this sets up the conditions for mean reversion and for investors to take a contrarian approach. Pure (unloved) value stocks are those companies which are intrinsically cheap based on a simple ‘sum of the parts’ valuation of their business.

Using mean reversion involves identifying the trading range for a stock and calculating the average price or valuation. Profit warnings, which can happen for many reasons including cyclical or temporary setbacks, provide one example of mean reversion in action. The chart below shows that the performance of most stocks recovers after 18 months.

Mean reversion of share prices after profit warnings

Source: FIL Limited, MSCI.

Some sectors of the stock market occasionally get hot, others get cold. In 2000-2003, the share prices of technology stocks fell back to earth after the dot.com bubble. At the same time however, ‘old economy’ stocks like breweries - shunned during the bubble years for being boring - did particularly well as they positively reverted back towards the mean. The hot inflated sectors deflated and the cold, unloved sectors won over weary investors looking for reliable earnings.

Of course, cheap stocks can’t mean revert if they go bankrupt. This is where unstinting company and industry analysis comes in – separating value opportunities from value traps.

Let’s take Lloyds as an example. Like other UK and European banks, Lloyds shares were hit hard by the financial crisis as investor sentiment turned incredibly negative. The share price reached a trough of 21 pence in early 2009, having started the previous year above £2 a share. After seeing a modest relief rally in the middle part of 2009, the shares settled into a trading range before sliding again in 2011 on renewed fears over banks in the midst of the European sovereign crisis.

In the summer of 2011, the stock then fell out of its 12-month trading range due to scepticism in the market on the strength of the new management team and new chief executive Antonio Horta Osorio. The valuation of the business at this point reached an extreme versus history (Fidelity’s banking analyst moved the stock to a strong buy) and value investors saw their opportunity to buy a solid banking business that was well positioned in the UK market with limited downside. The stock has subsequently increased by around 70% (versus a 10% return in the FTSE100).

Lloyds: A classic value play

Source: DataStream, 6 years to 03 February 2014.

what are these?

Subscribe

RSSReceive the latest expert opinions as they are published - RSS feeds

iPhone appCustomise your mobile experience with Fidelity's new app for the iPhone and iPod Touch. Fidelity UK app available in the App Store

 

 


 

Fidelity disclaimer

The objective of this page is to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications. Content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or investment by any Fidelity entity or any third-party.

Terms of use for Third-Party Content and Research