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Mean reversion has two important consequences for investors: Undervalued, out-of-favor stocks tend to beat the market. Glamorous, expensive stocks don’t. Fast-growing businesses tend to slow down. Highly profitable businesses tend to become less profitable. The reverse is also true. Flatlining or declining businesses tend to turn around and start growing again. Unprofitable businesses tend to become more profitable.
You don’t need to be a lawyer, a chartered financial analyst, a tech genius, or a Harvard graduate to get this book. Buffett wrote in 1984, “It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all”:1 A fellow…who had no formal education in business, understands immediately the value approach to investing and he’s applying it five minutes later.
Billionaire value-investor Warren Buffett famously says he tries to be “fearful when others are greedy, and greedy when others are fearful.” Said in other words, Buffett zigs when the crowd zags.
Icahn explains why:4 The consensus thinking is generally wrong. If you go with a trend, the momentum always falls apart on you. So I buy companies that are not glamorous and usually out of favor. It’s even better if the whole industry is out of favor. Icahn zigs when the crowd zags.
Billionaire trader Paul Tudor Jones is a well-known contrarian. In Jack D. Schwager’s Market Wizards (1989), he said: I learned that even though markets look their very best when they are setting new highs, that is often the best time to sell. To some extent, to be a good trader, you have to be a contrarian. Paul Tudor Jones zigs when the market zags.
Thiel’s “sweet spot” is a good idea that seems like a bad idea to the crowd. But Thiel thinks it might be a good idea. Thiel’s zigging while the crowd zags.
In his autobiography, Steinhardt described how he told an intern what he looked for:5 I told him that ideally he should be able to tell me, in two minutes, four things: (1) the idea; (2) the consensus view; (3) his variant perception; and (4) a trigger event. No mean feat. In those instances where there was no variant perception…I generally had no interest and would discourage investing.
Billionaire global macroinvestor Ray Dalio says:6 You have to be an independent thinker in markets to be successful because the consensus is built into the price. You have to have a view that’s different from the consensus. Dalio is saying you only beat the market if you zig.
The last one surprises many new investors. You don’t beat the market if you’re right and you zag along with the crowd? Nope. You don’t beat the market when you’re right if the crowd has already decided the stock is a good one. The reason? As we’ll see, you pay a high price that reflects the crowd’s high hopes for the stock. Even if the stock meets those high hopes, it won’t beat the market.
You can’t beat the market by zagging along with it. To beat it, you must zig as the crowd zags. Here’s why: the only way to get a low price is to buy what the crowd wants to sell and sell when the crowd wants to buy.
A low price means a price lower than the stock’s value. It means an unfair, lopsided bet: a small downside and a big upside. A small downside means the price already includes the worst-case scenario. That gives us a margin of error. If we...
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A bigger upside means we break even, though we have more losses than successes. If we manage to succeed as often as or more often ...
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Thinking like an owner implies three ideas: We should know what the company does. What is its business? How does it make money? We should know what it owns. What are its assets? What does it owe? We should know who runs it and who owns it. Is management doing a good job? Are the big shareholders paying attention?
Why buy a company with a failing business, even if it is undervalued? There are three reasons: It might have valuable assets. The crowd often sells a stock based on its business alone, ignoring its cash and other assets. Many seemingly scary, bad, or boring businesses turn out to be less scary, bad, or boring than they seem. Poorly managed companies attract outside investors who might buy them or turn them around. This is what private equity firms and activists do for a living. But shareholders don’t have to wait on other investors. They have rights as owners, and they exercise those rights by
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How do we know if any given bad business will get better with time? We don’t. But we know many bad businesses will. The reason is a powerful market force known as mean reversion, a technical name for a simple idea: things go back to normal.
Mean reversion pushes up the prices of undervalued stocks, and it pulls down the prices of expensive stocks. It returns fast-growing and high-profit businesses to earth, and it points business with falling earnings or growing losses back to the heavens.
Fast growth and high profits attract competitors—entrepreneurs and businesses in related industries. Competitors eat away at the growth and profit. Losses cause competitors to fold or simply leave the industry, and the lack of competition creates a time of high growth and profit for the surviving businesses.
Mean reversion has two important implications for investors: Undervalued, out-of-favor stocks tend to beat the market. The more undervalued the stock, the greater the return. Value investors call the difference between the market price and the underlying value the margin of safety.
The bigger the margin of safety, the better the return. This is why we ignore advice like the old saying, “Never catch a falling knife.” Undervalued stocks are lower risk than glamorous, expensive stocks, which have no margin of safety. Fast-growth or highly profitable businesses tend to slow down or become less profitable. Declining or unprofitable businesses tend to do better.
Investors make the error worse by overpaying for unsustainable growth or profit. They extrapolate out the profit trend and buy. If the stock delivers on the promised growth or profit, it only earns a market return. If it doesn’t, it gets crushed.
They buy at what looks like the worst possible time, when profits are falling or losses are widening, and it looks like this will continue until the crashing stock hits zero. It’s the worst-case scenario. But the stock is undervalued, and it offers a wide margin of safety. It’s time to buy. As Klarman says, “High uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen.”14 They’ll also sell at what looks like the best possible time: profits are high and rising quickly, and it looks like this will continue forever. The stock
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In our test, the Acquirer’s Multiple—fair companies at wonderful prices—beats the Magic Formula—wonderful companies at fair prices. It seems the size of the margin of safety—the market price discount from value—is more important than profitability.
The Acquirer’s Multiple buys stocks with mixed profits; some are highly profitable, others break even, and others lose money. It relies on the price mean reverting to the value and the businesses improving.
Buffett seeks stocks with sustainable profits, those that have what he calls a “moat”—in other words, a competitive advantage. A moat is something that allows a business to beat its competition.
But our chance of finding a business that can sustain profits is still as good as flipping a coin. There are three reasons why: Only a few businesses have a moat. Most don’t. It can be hard to tell a business with a real moat from one that is at the peak of its business cycle. A moat is no guarantee of high profits. Coke’s brand allows it to sell its cola for more than other colas. But if tastes change to other sodas, or water, Coke’s profits will fall. Moats don’t last forever. Newspapers used to have a moat. If you wanted to advertise in a city, you advertised in the local paper. There was
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Sanborn Maps was a typically profitable investment for Buffett. It was also a good example of Buffett’s instinct to zig when the crowd zags. The market saw the failing map business. Profits had fallen steadily for more than twenty years. But Buffett looked past the 80 percent drop in profit to the asset value—its $65 per share in cash and investments.
This is the buffet strategy sandstorm maps
In the same letter that he revealed his holding in Dempster, Buffett described his investment strategy. He said he split his investments into three groups: Generals Workouts Control situations Generals were simply undervalued stocks. Buffett bought
the stock at a big discount to its value and sold when the market pushed the price up to the value. The workouts were stocks on a timetable. They did not wait on market action. Some other force put these stocks on a rocket sled. That force was a corporate action, a board-level decision that delivered a big return of capital or stock buyback, a liquidation, or a sale of the business.
If a general—one of Buffett’s undervalued stocks—stayed undervalued for too long, it might become a control situation. Buffett would simply keep buying until he owned enough to control the company. Dempster started out as just anoth...
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The ability to get control of the company was important to Buffett because it gave him control of the stock’s destiny. Stocks either moved up or Buffett moved in and fixed them up. It worked. And it worked best in down or sideways markets. Either way, Buffett beat the market like a rented mule.
As long as the stock was undervalued when Buffett bought it, he could wait patiently. But he wouldn’t wait forever for the sleeping shareholder to wake up. If the undervalued stock’s price did nothing for a long time, Buffett would slowly buy a big shareholding. Then he would take control.
Our willingness and financial ability to assume a controlling position gives us a two-way stretch on many purchases on our group of generals. If the market changes its opinion for the better, the security will advance in price. If it doesn’t, we will continue to acquire stock until we can look to the business itself rather than the market for vindication of our judgment.
Candies for $25 million. Why was Buffett willing to pay so much? He saw the value in See’s customer franchise. See’s chocolate was especially high quality. Chocolate lovers preferred it to candy that cost two or three times as much. Also, the customer service in See’s shops was “every bit as good as the product.”29 It was “as much a trademark of See’s as is the logo on the box.”30
For example, let’s say we have two businesses, each earning $1 million in profit. One has $5 million in assets. That’s the good business. The other has $20 million in assets. That’s the bad business. We can invest in the good business, we can invest in the bad business, or we can leave our money sitting in long-term bonds. Return on Capital: High Profitability Is Worth More The good business earns 20 percent on its $5 million in capital ($1 million ÷ $5 million = 20 percent). The bad business earns 5 percent on $20 million ($1 million ÷ $20 million = 5 percent). The long-term bonds yield 10
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A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful worldwide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
“I’d rather have a $10 million business making 15 percent than a $100 million business making 5 percent. I have other places I can put the money.” —Warren Buffett to Ken Chace, President, Berkshire38
The Acquirer’s Multiple works the same way, but it includes more data than the PE multiple. Stocks with low Acquirer’s Multiples tend to do better than stocks with low PE multiples over time. The Acquirer’s Multiple works better than the PE multiple because it is better at working out a stock’s true price and its true earnings.
We already know Red Soda made $2 million and Blue Soda made $1 million in operating earnings last year. If we pay the same amount for each company, say $10 million, the Acquirer’s Multiple will be 5 for Red Soda ($10 million ÷ $2 million) and 10 for Blue Soda ($10 million ÷ $1 million). Red Soda is cheaper than Blue Soda because its Acquirer’s Multiple at 5 is lower than Blue Soda’s Acquirer’s Multiple at 10. This is true even though we pay the same amount for each, $10 million. A lower Acquirer’s Multiple means we get more operating earnings per dollar spent on shares of Red Soda.
Let’s put the return on equity and the Acquirer’s Multiple together. Greenblatt is looking for a stock that makes a lot of profit for each dollar invested in it. At the same time, he wants to pay as little as possible for each dollar it makes. He wants a wonderful company at a fair price. Magic Formula = Wonderful Company + Fair Price If we have the choice of investing in Red Soda or Blue Soda, we prefer Red Soda. Why? Because it has a higher return on equity (20 percent versus 10 percent for Blue Soda) and a lower Acquirer’s Multiple (5 versus 10 for Blue Soda). Red Soda is more wonderful and
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In dusty, old finance journals, it is described it as the Acquirer’s Multiple because corporate raiders and buyout firms—the acquirers—used it to find whole companies cheap enough to take over.
The Acquirer’s Multiple compares the total cost of a business to the operating income flowing into the company. It assumes the acquirer can sell assets, pay out the company’s cash, or redirect the business’s cash flows.
The Acquirer’s Multiple is the enterprise value divided by operating earnings.
Companies with enterprise values of $0 (and less) do exist. A low or negative enterprise value is a good thing to find. It means the company has little debt and lots of cash relative to the market cap.
Operating Earnings = Revenue - Cost of Goods Sold - Selling, General, and Administrative Costs - Depreciation and Amortization
Operating earnings are very similar to earnings before interest and taxes or EBIT.
Euclidean simulated portfolios of thirty stocks from 1972 to 2017. Portfolios of Acquirer’s Multiple stocks were compared to portfolios of Magic Formula stocks and the market. Euclidean ran the test in each of Greenblatt’s three universes: stocks with a market caps bigger than $50 million, $200 million, and $1 billion. The results are stunning. (For details on the simulation, see the appendix.) Market Cap $50 Million And Above
$10,000 Invested in Acquirer’s Multiple, Magic Formula, and S&P 500 (1973 to 2017) In our $50 million market-cap test, the Acquirer’s Multiple beat the Magic Formula. Both beat the S&P 500. The Acquirer’s Multiple compounded at 18.6 percent yearly. The Magic Formula managed a respectable 16.2 percent yearly. That small advantage to the Acquirer’s Multiple made a big difference over the full forty-four years. A theoretical $10,000 invested in each strategy became $18.7 million for the Acquirer’s Multiple and $7.6 million for the Magic Formula. Market Cap $200 Million And Above $10,000 Invested
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$10,000 Invested in Acquirer’s Multiple, Magic Formula, and S&P 500 (1973 to 2017) Finally, in our biggest $1 billion market-cap test, the Acquirer’s Multiple beat the Magic Formula by a wide margin. Both beat the S&P 500. In the biggest universe, the Acquirer’s Multiple compounde...
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