As a team, we invest in companies that are significantly out-of-favour and cheap, based on a sensible assessment of their normalised profitability. A price we pay for doing this is that, generally things look fairly unattractive when we invest. But as believers in reversion to the mean, we believe there is an underappreciated tendency for companies that are doing badly to do better and for companies that are doing well to do worse.
And importantly, because out-of-favour companies are doing badly, they tend to be cheap. As an old stockbroker told me when I started out in investments, “We’re not here to find good or bad companies, young man. We’re here to find cheap and expensive ones.” Not all currently out-of-favour companies are necessarily bad, or the in-favour ones, good.
There are a number of drivers of reversion to the mean. One is good old competition. If a company or an industry is doing particularly well, then new capacity or new players are likely to enter the market. Whereas in a market that is performing poorly, there is lesser incentive for new players to enter.
Then there is regulation. Companies or markets that are doing particularly well, are more likely to attract adverse regulatory changes. This is far less likely in industries that are struggling, where there is scope for favourable regulatory changes.
Investors should also acknowledge the unpredictability of the future. Human beings tend to think they have better foresight than they actually do. Life throws us curve balls, and sometimes we do not see them coming. And with popular companies priced predominantly for a stream of good news, the risk is that some of these surprises are bad and can dilute the stock’s attraction. With unpopular companies priced predominantly for bad news, surprises are more likely to improve the mix.
The driver of change in fortune that I personally find interesting is complacency. It receives relatively little attention, and yet, I suspect that it is much more powerful than most people give it credit for. You can see it in the attitude of a company’s management team when you meet them. The management of a company that is doing well are generally praised, are typically well paid and look to have promising careers ahead of them. Faced with this, it is hard not to relax to some degree, and unfortunately this comes at a time when the other drivers of the change in fortune are building in the background, to make things more challenging.
By comparison, the management of a company that is not doing well are likely to be criticised in the press and be under pressure from their shareholders. The amount that they are being paid is likely to be suffering and their jobs could well be at risk. It is only human nature for this to get you out of bed a bit earlier in the morning, and for it to make a management team focus more clearly on realising shareholder values. Costs are likely to come under greater scrutiny, and previously unpalatable, but value-enhancing disposals or corporate activities are more likely to be considered.
For these and other reasons, we believe the odds of investment success are more in your favour when you invest in unpopular assets. And that is what we will continue to do.