Using Momentum, Mean Reversion For Possible Advantage

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Using Momentum, Mean Reversion For Possible Advantage

Using Mean Reversion and Momentum for Possible Advantage by David Merkel, CFA of AlephBlog

One of the challenges of fundamental investing is trying to find decent ideas that are off the radar. There are a number of ways to try to do that by looking at:

  • smaller foreign companies
  • companies that have made some significant losses.
  • companies where the relative performance is so awful that no manager benchmarked to an index would dare touch the company.
  • small companies with modest insider buying.
  • companies in boring industries that you know can’t have any significant growth.  (This excludes “buggy whip” industries.)
  • companies where insiders own so much of the company, that it can’t easily be taken over.
  • complex companies that are difficult to understand.

Okay, tall order.  That said, I’ll do a few articles over the next two months that try to unearth companies that might be suitable candidates for analysis.  Tonight’s article follows up on what I wrote in my last article, where I said:

Sometimes I like to run a screen for stocks have done badly over the last four years, but have begun to outperform over the last year.  This can point out areas that are still ignored by most of the market, but where trend may have shifted.  I’ll post that screen after my software has its weekly update on Saturday.

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I’m going to show you the list, with some additional data to give some context, but remember this: the only reason these stocks are here is that they underperformed the market massively for the last four years, and have had a turn in performance in the last year.  Anyway, here is the list:

BADTHENGOOD_21692_image002 mean reversion
mean reversion

I’ve been analyzing stocks for over 20 years… out of the 49 companies listed here, I recognize 24 of them.  I own none of them at present, though I have owned four of them in the past [AKS, DYN, TNP & YRCW].  That said, four years of lousy relative performance likely means that few are actively looking at these companies.

As with any analysis on the internet, purchasing or selling shares of companies like this is at your own risk.  I’m planning on looking through this list for ideas, and if I find one good enough to buy for my clients and me, I will do a write-up after we have established our position.

In order to get there, I would have to be satisfied about a number of things regarding any one of these companies:

  • What went wrong over the last four years?
  • Has management fixed what was wrong?  (Or, is there a new management with better ideas?)
  • Is the business adequately capitalized?
  • Is the accounting likely honest/conservative?
  • Do they have a large area where they can earn money sustainably, or are they up against stronger competition almost everywhere?
  • If they are in a tough industry, are they one of the few that could survive if conditions got markedly worse?
  • Does management seem intelligent in using excess cash?

The question is to look for a margin of safety, and then see whether the company will earn a return on its business that is attractive at your entry price.  This is a challenge, but maybe one or two companies out of 49 could make it.

Or not.  Be careful.

Updated on

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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