Has the internet invalidated reversion to the mean? with Tobias Carlisle
Reversion to the mean – the idea that while investment prices and returns can swing heavily up or down in the short term, they will eventually move back or ‘revert’ to their historical average – is fundamental to value investing. But what happens if, as some commentators now argue, the internet has so disrupted businesses and markets that, at the same time, it has invalidated the century or more of data that shows value outperforms?
We recently had the opportunity to put this question to value investor and author Tobias Carlisle when he took part in our podcast.
Moving on from a wider discussion on whether value was ‘dead’ or set to bounce back, we asked him to think about other transformational periods of history that might be analogous with what investors are experiencing as a result of the internet.
In response, Carlisle pointed to research by O'Shaughnessy Asset Management that considered a similar time of disruption – as the car and all its associated infrastructure, such as roads and petrol stations, replaced the horse. “In the 1920 and 1930s, as everybody went from owning a horse to just about everybody owning a car – that had a similar kind of impact to the internet,” he argues.
“And, if you look at the price-to-book value data, you will see a 16-year period from 1926 to 1941 – something like that – where price-to-book value got destroyed. But then, after a while, things went back to a much more usual market for value and the strategy started working again.” What is more, he points out, value investors are not in the habit of just sitting on stocks and watching them go to zero.
“Value investors are reconstituting their portfolios on a regular basis,” Carlisle continues. “So if I am looking at a business on a historical free cashflow ratio or whatever, I want to buy it with a 10% or a 15% yield. But, if I’m wrong and that yield doesn’t recover – it keeps on going down – that will cease to be a value stock and I will reconstitute the portfolio with something else that has a better yield.”
We may have been through an extended period where a transformation appears to have occurred but, argues Carlisle, it is simply not the case that individual companies take over whole industries – instead, what tends to happen is incumbents adopt the new technology, whatever it might be. “Remember the first dotcom boom?” he asks. “People thought the dotcom companies would be able to wipe out all the incumbents.
“Instead what happened, though, was the incumbents just got a website and, for the most part, started selling over the web – and a similar thing is happening now. I would therefore argue what we are seeing is just a cyclical boom rather than a really transformational period but, either way, we are getting closer to the end of it than we are to the start of it.
“So mean reversion certainly still does work. The idea you can buy something and get a fatter cashflow than you can from something else that might be losing money – I still find that to be pretty compelling logic. You can hold something like that and, as the price increases and the cashflow yield goes down, you transition to something else with a fatter cashflow yield. That’s just how traditional value investing works.”
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