As we discussed on Friday, to be a successful investor, you need to buy low and sell high.
That’s easier said than done.
But one powerful phenomenon can be very useful in helping investors hunt for sectors that look cheap.
It’s called ‘reversion to the mean’, and the good news is that it’s a lot simpler than it sounds.
What goes up must come down – and vice versa
One powerful factor to take account of when investing is ‘reversion to the mean’.
To put it simply, the idea behind mean reversion is that when asset prices appear out of whack compared to their historical norms, then it’s reasonable to bet that they will return to trend eventually.
Of course, it’s never that simple. As Mark Hulbert points out on MarketWatch.com, there can be “widespread disagreement on what is the mean to which the markets are supposed to regress.” You’ll always find someone who can draw a convincing line on a chart that suggests the trend is for the market to continue higher.
But say you take a look at a more widely-accepted fundamental measure of value, such as the cyclically adjusted price/earnings (CAPE) ratio. This averages out corporate earnings over ten years, giving a better idea of whether stocks are cheaper or more expensive than average. On this measure, many developed-world markets look over-priced. For example, based on the CAPE, Jeremy Grantham of GMO reckons the ‘fair value’ for the S&P 500 is around 920.
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You may well ask: if that’s the S&P’s fair value, then why is it trading so far above that just now, at around 1,339? The automatic reaction is to suggest that a measure of value has lost its predictive power. Or that ‘ it’s different this time.’
However, the reality is that markets often aren’t trading where they ‘should’ be. They tend to trade on either side of ‘fair value’ – they rarely sit bang on fair value. That’s because many investment decisions are backward-looking. Investors just extrapolate past trends into the future. A rising market will keep going up. A falling one will keep going down.
The reason that mean reversion is a useful concept is because it gives you some sort of objective idea of whether a market is cheap or expensive. When it’s expensive, the chances are it’s heading for a fall to below fair value at some point in the future.
Of course, you don’t know when that’s going to happen. The market can remain irrational for longer than you can remain solvent, and all that. But unless you’re trying to short a sector, the fact is that a long-term investor can afford to sit on paper losses. The psychological pain of doing so can cause you to sabotage your portfolio by trading carelessly. But if you have a strategy in mind when you buy into a market or sector, the psychological stress won’t be as bad.
So if you’re the sort of investor who likes to buy and then put an investment to the back of your mind, then you’re better looking for investments that are cheap compared to their historical fair value. That way, you hopefully don’t have to be checking on the state of your portfolio every five minutes.
One sector that looks cheap on historical terms
So does anything look decent value just now?
One thing we’ve been focusing on for some time now is defensive stocks paying solid dividends. With inflation rising, but fears of a slowdown in growth, we want stocks that pay a decent income but also have the capacity to stand up to tougher times.
One sector that looks interesting on this basis is telecoms. As Neil Hume pointed out in the weekend FT, the gap between the dividend yield on the European telecoms sector and that on the wider market is at an all-time high. In other words, your typical stock in the telecoms sector is yielding a lot more than your average stock.
According to a report from Jonathan Stubbs at Citigroup, the yield is around 7%, roughly twice that of the wider market. This is pretty unusual for any sector, not just telecoms stocks. Indeed, says Stubbs, a gap this wide has only been seen four times in the past 40 years. If you’d bought the sectors in question, you’d have made an average 12-month return of 27%.
Of course, not every telecoms stock is going to do well. But if you’re looking for a simple, straightforward company to add to your portfolio, then try Vodafone (LSE: VOD). It’s hardly the most exciting tip in the world. But then, exciting isn’t always what an investor should be looking for. With a current dividend yield of around 5.5%, and the hope of an increase once its US joint venture with Verizon starts paying a dividend, the mobile giant looks a solid investment for uncertain times.
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