Sunday, August 29, 2004

On Mean Reversion

In a comment to an earlier entry, my friend Bharat asked me about Mean Reversion and if I use it. Definitely!

Mean Reversion is normal with stocks since too often people tend to act emotionally rather than rationally on good/bad news and extreme reaction (on either side) is a daily occurence. Just using this phenomenon, you can make a good chunk. The most important quality you need to use this is patience, since there is no set timetable for the eventual return to the mean.

A lot of my non-M&A picks belong to this category. You can play mean reversion both on the long and the short side, but short-selling is something that I haven't gotten into seriously. So i just look for companies whose stock get battered on bad news, but the underlying business model is still stable.

One recent example : Synopsys (SNPS) has gone from around $31/share to $15/share in 6 months on a stream of bad news. Around $32/share there were atleast 2 strong-recommendations from investment mags, and at $15/share no one seems to be interested, with some even asking you to sell! Yeah - buy high, sell low!

Synopsys's dominant position is still intact and at its current price it is a bargain. It will recover eventually (I would say 1-3 years) and if you have a few grand to spare, buy this one! You won't regret it. I added some recently after watching it for a long-time. Since this isn't a takeover target, I will be selling it when enough analysts start asking you to buy (probably at much higher levels than the current one).

Mean Reversion is even more appealing with a stock that pays a dividend, assuming that the dividend is not threatened. This is very, very rare. A dividend stock takes a much lighter hit on bad news, and a lot of automated buys kick in when the yield crosses a threshold, thus placing a cap on the downside.


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