Novel Investor

Compounding investing wisdom...

Defying Reversion to the Mean

by Jon

Mean reversion is a powerful force. It drives market cycles, stock prices, profit margins, earnings, growth rates…you name it.

Michael Mauboussin wrote a piece about it in 2007 based on ROIC. ROIC (Return on Invested Capital) measures the profitability of a company. Positive is good, high is better, persistently high is great. Here’s the gist of his piece:

Exhibit 5 shows one measure of persistence: the degree of quintile migration. This exhibit shows where companies starting in one quintile (the vertical axis) ended up after nine years (the horizontal axis). Most of the percentages in the exhibit are unremarkable, but two stand out. First, a full 41 percent of the companies that started in the top quintile were there nine years later, while 39 percent of the companies in the cellar-dweller quintile ended up there. Independent studies of this persistence reveal a similar pattern. So it appears there is persistence with some subset of the best and worst companies. Academic research confirms that some companies do show persistent results. Studies also show that companies rarely go from very high to very low performance or vice versa.
Continue Reading…

Highlights from Howard Marks’s Mastering the Market Cycle

by Jon

Howard Marks’s latest book, Mastering the Market Cycle, is a compendium on the different cycles investors contend with. The book stands as a lesson on observation over prediction. It’s a solid addition to his classic The Most Important Thing.

Since I just started on my notes on the book, I thought I’d leave market cycles for another day. Instead, I want to share some highlights from the book.

I avoided his more popular idioms, as well as quotes from his memos that he always includes in his books, and focused on the secondary lessons that stood out.

Let’s dive in: Continue Reading…

Sitting at a Loss

by Jon

Had you bought the S&P 500 on January 1st of any year since 1922, 68% of the time you’d have more money one year later. Using the Dow produces similar results — roughly 68%.

Both those stats ignore dividends, by the way, which would help improve those odds.

The idea behind it should set aside the concern of buying at a market top, only to sit at a loss for any number of years. It happens. No amount of market timing will prevent it. And worrying about it, based on those odds, appears to be overrated.

It’s interesting that those numbers don’t change much if you look even further back in time. Which is exactly what Edgar Lawrence Smith did: Continue Reading…

Early Principles of “Investment Management”

by Jon

Edgar Lawrence Smith concludes his classic book with the importance of “Investment Management.” I don’t know how original this concept was in 1924, but investment management is exactly like it sounds. Anyone who’s read a few investing books should recognize the principles Smith lays out since it fits the basic concepts of investment planning today.

Obviously, the big difference between then and now is that most investors are analyzing funds or strategies instead of individual stocks and bonds. And analyzing might be an exaggeration.

Smith’s point falls under the Peter Lynch maxim of “Know what you own” and keep a watchful eye over it.

But first you need a sound plan. He lays out the case for management as an ongoing effort to balance a portfolio between stocks and bonds based on whatever the current environment warrants.

Then he expands into having a plan for the long term (including the next generation), the importance of diversification, and understanding the limits of what’s possible.

Here’s how Smith broke it down: Continue Reading…

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