Takeaway number 1: Zig when everyone else zag
Zigging when everyone else is zagging means buying what the crowd wants to sell and selling what the crowd wants to buy
"To beat the market, you must do something different from the market"
But don't take my word for it! Ray Dalio, founder of the investment firm Bridgewater Associates and
owner of $18.7 billion says that:
"You have to be an independent thinker in markets to be successful, because the consensus is built into the price"
Carl Icahn, the famous activist investor with a net worth of $17.1 billion explains that:
"I buy companies that are not glamorous and usually out of favor. It's even better if the whole industry is out of favor."
According to Howard Marks, another billionaire investor: "To achieve superior investment returns you have to hold
nonconsensus views regarding value, and they have to be accurate."
And according to the macro investor Michael Steinhardt, who produced a return of 50,000% for his investors in Michael Steinhardt & Partners:
"You must have a variant perception"
Now, why is it so important to be nonconsensus? One word: mean regression
Yeah ... two words perhaps.
Takeaway number 2: Regression to the mean
In Daniel Kahneman's book "Thinking Fast and Slow", Kahneman tells a story about when he was coaching Israeli flight instructors
One of the instructors had (wrongly) drawn the conclusion that
punishment for bad performance works better than rewards for improved performance
He said: On many occasions
I have praised flight cadets for clean execution of some aerobatic maneuver. The next time they try the same maneuver, they usually do worse!
On the other hand ..
I've often screamed into a cadet earphone for bad execution, and in general, he does better on his next try
What the Israeli flight instructor was witnessing wasn't that punishment is more effective than rewards, what he was witnessing was
regression to the mean
Simply put - when a flight cadet was able to do these advanced maneuvers, it was an outlier,
something that he wasn't usually able to do. His expected performance was actually lower,
so no wonder that he wasn't able to repeat it a second time!
On the other hand, when a flight cadet was making a lot of mistakes,
he performed lower than his expected performance, but after a while, his performance got back to normal again
Regression to the mean doesn't just apply to Israeli flight carrots, but also to ...
Gaming girls! One night in the club, you are the absolute king, but the next day ...
Regression to the mean.
YouTubing! For a short period of time, you seem completely unstoppable ,
and while you are calculating how many months it will take before you have surpassed Pewdiepie ...
Regression to the mean.
But more importantly, it applies to the stock market as well
Prices, profit growth and profitability all regress to the mean
"Corrective forces are usually set in motion
which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital"
Probably the strongest of these corrective forces that Benjamin Graham talks about is competition
Rapid growth of earnings and/or high profit margins in an industry attract competitors,
while a decline in earnings and/or negative profit margins weed companies out
Michael Mauboussin presents a great example in his book "The Success Equation"
He divided 1,000 companies into five groups in the year 2000, based on their average profitability
He then watched how the average changed over the period 2000 to 2010. The results are quite astonishing.
Although the most profitable companies from the year 2000 remained the most profitable ones in
2010, the gap between the groups shrunk dramatically
Quite a few scientific articles support regression to the mean in the stock market too - and Tobias Carlisle states:
"Weak current profits in a stock with a good past record creates a good chance for deep value contrarians to zig"
Moreover, he says that: "The key to maximizing returns is to maximize our chance at mean reversion"
So, how do we do that exactly?
Let's see next.
Takeaway number 3: The Acquirer's Multiple
During the years
1973 to 2017, the S&P 500 index returned an average of 10.2% per year
This is pretty good. $10,000 invested in 1973 turned into $741,000 in 2017
But following a strategy which you are about to learn very soon -
systematically buying companies with the lowest Acquirer's Multiple - you would have done much better
During the same period, you would have returned
18.6% per year, which means that the same $10,000 invested in
1973 would have turned into $18,700,000 instead
So what is the Acquirer's Multiple?
It's like an enhanced price to earnings multiple. The price to earnings multiple, or P/E multiple, is
calculated by taking the market cap of a company and dividing it by its earnings
This ratio is often referred to when discussing whether a stock market company is cheap or expensive
A P/E or for instance 30, means that you pay $30 for every $1 of earnings in the company, while a P/E of 10
means that you pay $10 for every $1 of earnings
Everything else equal, you'd rather pay $10 than $30, so you want as low of a P/E multiple as possible
The Acquirer's Multiple makes up for some of the weaknesses that the P/E multiple has
It is calculated by taking a company's so called enterprise value and dividing it by its operating earnings
Let's break this down
The enterprise value differs from the market cap in that it also takes cash reserves and debts into account
A great illustration is to view the market cap as the tip of an iceberg
The problem with P/E is that it doesn't take into account if the company has a lot of debt,
which is negative, or a lot of cash, which is positive
Enterprise value does
You can calculate the enterprise value by taking market cap + total debt - cash and cash equivalents
And the formula for calculating operating earnings is this
Warren Buffett says that in his Berkshire Hathaway, his main focus is to build operating earnings
We want to buy companies with the lowest Acquirer's Multiple
possible, because that means that we are paying as little as possible for the operating earnings after
distributing all cash and repaying all debt, much like an acquirer of the whole company could decide to do
With a low Acquirer's Multiple,
We have made sure that we are paying a low price, while also maximizing the chances for the previously mentioned
regression to the mean,
because, companies where you don't have to pay much for the earnings are typically way out of favor with the rest of the investing community
This means a small downside and a large potential upside
Let's check out how we can accomplish this in practice
Takeaway number 4: The broken-leg problem
Here's how to implement the Acquirer's Multiple strategy
1. Go to acquirersmultiple.com and sign up for a free account
2. Purchase about 20 of the stocks that rank highest in the screener,
meaning, the 20 companies in that stock universe with the lowest Acquirer's Multiple
3. Update your portfolio every quarter
Switch out the stocks that are no longer on the list for those that are
Any stock with a profit on should be kept for a minimum of one year and one day though, for tax purposes
For many problems simple rules such as these make better decisions than experts
Experts make better decisions when they are aided by simple rules, but the simple rules themselves are even better. Why?
Because of the broken-leg problem
Imagine that you have some type of simple and measurable rule to decide whether Adam and Sarah will go to the movies together
Now, if you know that Adam broke his leg just the other day,
you'd probably want to override this rule, as your simple rule probably can't take this information into account
The issue though, is where to draw the line
Should we override the rule if Adam has a flu?
If Adam's brother is visiting town?
If The Swedish Investor recently released a new video?
The problem is that we tend to make our own decisions too often,
and in that we ignore the simple rule and include too much irrelevant data
We find broken legs everywhere!
Some companies are able to sustain high profitability over longer time periods without
regressing to the mean, but few people can identify the companies that will
Most of us are probably better off just sticking to a simple rule, in this case,
buying anything that has a low Acquirer's Multiple and selling anything that has a high one
Takeaway number 5: So ... why doesn't everyone do it?
There's another, even more famous method for picking undervalued companies, which was invented by Joel Greenblatt
His method is called "The Magic Formula" and I published a video about his book "The Little Book that Beats the Market"
about half a year ago
Coincidentally, that video exploded in views just the week before I released this one, but that's not the point
The point is one of the most common questions that I've been receiving on that video
Anticipating that a lot of you will ask the same thing here, I will try to be one step ahead
So, if it's as easy as a 1-2-3 process to outperform the market: Why doesn't everyone do it?
It's a funny thing, because the answer is partly in the question. If you don't believe it works, why would everyone else believe it?
Moreover, it takes persistence and guts to stick to this, especially when the market is heading in the other direction
It can easily be compared with, for instance, working out and staying fit
I think that's pretty much 99% of people that are obese know what they have to do
It isn't that difficult, just go to the gym five days a week, eat healthy and sleep well!
So why doesn't everyone do it?
Because although it's easy in theory, it isn't in practice. It takes persistence,
sacrifices and dedication, just like following a stock market strategy that is based on zigging what everyone else is zagging
And that's it!
If you want to learn about another method that can help you in finding undervalued companies in the stock market, using quantitative data only,
head over to my summary of "The Little Book that Beats the Market" by Joel Greenblatt
Cheers guys!