How You Can Beat an Olympic Swimmer With Cheap Stocks

Why can an olympic swimmer keep beating me in the pool while his portfolio is barely treading water?

Cheap Stocks: What Are the Odds?

The reason I talk so much about setting the odds in my favour is because investors really don't know what's going to happen in the future. There are tendencies, probabilities shown through experience, but tendencies aren't certainties. The best an investor can do is to look at the tendencies of the past and, through sound reasoning, assess current situations based on those tendencies.

One tendency critical to value investing is mean reversion. Mean reversion is just the tendency for outlier cases to revert to a more typical value or occurrence. Take family height. A man and women who are extremely tall can be expected to have tall children. The tendency, though, is for those children to be somewhat smaller than their parents. Each successive generation will gravitate further towards average human height until the family's height is more or less consistent with the average height of that place and time. In this way, family height tends to revert to the mean population height.

Mean reversion is a strong force in investing which should lead investors to two conclusions. The first is that most money managers who have performed well over a number of years will revert back to the typical performance for money managers as a whole. The key word here is most and that qualification is key when it comes to beating an Olympic swimmer. Picking hot money managers does not add value to your savings, in most cases. Unlike swimming, money management is not overwhelmingly based on skill. There is a strong element of luck involved, so the typical money manager will face his fair share of good and bad fortune. The second is that the fortune of most companies reverts back to a more typical, or average, level of profitability over time.

Because of these two implications of mean reversion, investors should avoid both the typical hot money manager and hot stock in favour of cheap stocks -- value stocks -- or money managers that have a solid track record of making good investment decisions based on the available information. This typically happens by buying by picking cheap stocks, stocks selling cheaply as compared to the value they represent.

Beating Oliver the Olympian With Cheap Stocks

When we dig deeper into managers as a whole, another thing becomes clear: some money managers have outstanding records going back decades. How is it that those managers can do so well for so long while the records of most money managers end up reverting back to the market average or worse? The secret for many of those outstanding money managers is taking advantage of reversion to the mean by basing their investment strategy on cheap stocks.

When it comes to investing your own money, the intelligent investor can look at how specific types of cheap stocks have fared as a group over time then invest in a basket of those stocks. Stocks in general have risen over at least the last 100 years. On average, stocks have a small tendency to rise in price year over year but any stock may rise or fall while you own it. Cheap stocks on the other hand, tend to rise in price by a larger degree year over year and seem to have more winners than losers in any given year. This gets to the heart of a mean reversion strategy -- selecting stocks trading at a low PE, PB, or price in relation to net current asset value means stacking the odds in an investor's favour.

If we accept that mean reversion is a law of finance then choosing temporarily troubled stocks should give investors a real edge. Selecting powerfully cheap stocks relative to value (whether value is based on characteristics intrinsic to the company or industry) means selecting stocks with the furthest to advance before becoming fairly valued. Risk, in terms of actual real sustained losses, is also reduced in proportion to possible gains.

These are likely two reasons why a net net stock investment strategy works exceptionally well. Since these stocks are trading at the cheapest valuations available to value investors, each company both offers a great risk-reward profile as well as a lot of ground to cover before reverting back to an average level of profitability.

This is how committed value investors can beat Oliver the Olympic swimmer in the investment arena. Taking advantage of mean reversion and cheap stocks -- specifically reversion based on deep price-value discrepancies -- is a super weapon when it comes to propelling your portfolio returns. Unfortunately, most investors don't take advantage of mean reversion when it comes to their portfolios.

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Here's a great YouTube video of Legg Mason's Michael Mauboussin talking about mean reversion and what it means for your portfolio.