The Magic Formula that Turns Ugly Ducklings into Beautiful Swans - Profit Hunter by Equitymaster
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The Magic Formula that Turns Ugly Ducklings into Beautiful Swans

Apr 16, 2018

Rahul Shah, Editor, Profit Hunter

Have you tried scolding your stocks after they have put up a bad show?

I've been doing this for the past four years with amazing results.

Of the 35 stocks I have scolded so far, 31 have gone on to improve their performance, giving an opportunity to my subscribers to make profits.

I learnt this brilliant idea from a fighter-pilot instructor who personally vouched for its effectiveness.

His own success rate using this trick had been amazing. Whenever he used to scream at cadet pilots for blunders, they usually did better. In contrast, whenever he praised them for doing well, they did worse on the next sortie.

Okay, admittedly I didn't actually scold my stocks - that story was a figment of my imagination. And even if I did, stocks are inanimate objects, devoid of any emotion - scolding them to improve performance sounds downright absurd.

What might come as a surprise to you is that even the second story is a figment of imagination - the imagination of the flight instructor in this case.

It isn't the instructor's scolding that was doing the trick. There was another process at work...

In fact, what led to the improved performance of stocks in the first story, and better maneuvers of the pilots in the second one, is the same phenomenon.

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The phenomenon goes by the name of reversion to the mean.

Now, don't get intimidated by the complex-sounding jargon.

At its core, reversion of mean is a simple yet very powerful idea.

You see, the trainee pilots did not improve their performance because of the scolding.

Those who were doing badly did better the next time because they were reverting to their mean, ie, their average performance. Their performance had deviated from what they were generally capable of, and therefore, in the next attempt, there was a strong chance they would do better (whether scolded or not).

Likewise, those who did well and got worse in the next attempt, did so because they had performed much better than they were capable of, and therefore, performance had to fall to the long-term average. Again, the praise had not much to do with it.

It is like watching Sachin Tendulkar bat... If the little maestro had a couple of very good outings, we knew in our hearts that a failure is around the corner. And if he had a few bad innings on the trot, we knew a great knock is just an innings away.

There again is mean reversion in action.

If there is a big deviation from the mean, sooner or later, the performance reverts to the mean.

Does this work on stocks too?

Absolutely.

In fact, one of the big reasons value investing outperforms all other forms of investing is because of this principle of reversion to the mean.

Richard Pzena, a noted investor in the west, puts it quite well.

  • On average, poor companies do better and on average great companies that are doing wonderfully, don't do as well. That is why value investing works because the markets extrapolate the same trends of high ROE companies continuing with the same or higher ROE while low ROE companies have lower to same trends extrapolated into the future. People just don't get it (reversion to the mean) despite many years of evidence."

If you are looking to form a portfolio, don't stuff it with companies that are doing way better than their average performance of the past. For if reversion to the mean is to be believed, most of these companies will revert to their long-term averages and therefore, show a deterioration in their fundamentals.

Companies that are doing worse than their historical performance on the other hand, can make for great investment candidates. For reversion to the mean in this case would mean that their performance improves, and so do their stock prices.

Guess what, in our Microcap Millionaires service, we follow this principle to the tee.

We don't look for beautiful, white swans that have the world at their feet...

...We look for ugly ducklings that have the potential to turn into swans based on the principle of mean reversion.

Of course, not all ugly ducklings turn into swans. There are the those that continue to remain ugly. And investing in these is a sure shot recipe for disaster.

Fortunately, we have found a formula that has a great track record of identifying the right reversion to mean candidates. Has it worked? Why don't you see for yourself.

CompanyReco. DateReco. Price (Rs)Closing Price (Rs)Gain/Loss (%)Closing Date
TITAGARH WAGONS20-Mar-14102658545.4%23-Feb-15
PURAVANKARA20-May-1648146206.0%8-Dec-17
LEEL ELECTRICALS LTD21-Apr-1464177175.9%20-Mar-15
HIL LIMITED20-Feb-14242654170.1%23-Feb-15
NAVIN FLUORINE20-Feb-14258696170.0%23-Feb-15
TECHNOCRAFT INDUS.21-Apr-1493233150.0%23-Feb-15
KANORIA CHEMICALS20-Mar-153688145.7%19-Oct-16
BIRLA CORP20-Mar-14241566134.9%20-Aug-14
IFGL REFRACT.20-Feb-1681182125.9%20-Dec-16
CENTURY ENKA18-Mar-16171358109.9%20-Mar-17
MAH. SEAMLESS20-Mar-15200420109.8%20-Jul-17
RENAISSANCE JEWEL20-Feb-16124258108.3%8-Dec-17
KAKATIYA CEM20-Feb-15114236106.6%4-Apr-16
MANGALAM CEMENT21-Apr-1413526999.6%20-Mar-15
GUJ.AMB.EXP.20-Apr-16489291.0%20-Jan-17
NALCO20-Feb-16335976.4%20-Dec-16
ARIES AGRO20-Sep-1610217673.3%20-Jan-17
SWELECT ENERGY SYSTEMS21-Apr-1425343471.7%20-Apr-16
GRAPHITE INDIA20-Feb-166611270.5%20-Mar-17
DREDGING CORP20-Feb-1542168462.5%20-Jun-17
NALCO20-Mar-14355659.4%20-Jun-14
ARCHIES LTD20-Apr-16223457.4%20-Apr-17
BHARAT BIJLEE20-Mar-1444667551.4%20-Jun-14
DREDGING CORP20-Feb-1745768449.6%20-Jun-17
TECHNOFAB ENGINEERING20-Feb-1513419343.7%20-Feb-17
GUJ.IND.POW20-Mar-14597934.3%18-Mar-16
BHEL18-Mar-16748413.7%20-Mar-18
HCL INFOSYS20-Mar-14374212.2%18-Mar-16
TARA JEWELS19-Aug-16353910.9%19-May-17
GUJARAT ALKALIES20-Jun-1419721710.3%20-Jun-16
GUJARAT STATE FERTILIZERS20-May-1474786.0%20-May-16
GLOBUS SPIRITS20-Jun-148165-20.3%20-Jun-16
SAIL20-Sep-147548-36.4%20-Sep-16
PENINSULA LAND20-Mar-143119-38.7%18-Mar-16
VENUS REMEDIES20-Feb-1421992-58.2%20-Feb-16
Source: Equitymaster

Of the 35 positions closed so far, 31 have made money.

That's like turning 9 out of every 10 ugly looking ducklings into swans.

A 90% success rate is off the charts in my view.

And what exactly is the formula all about? Well, above everything else, it involves buying companies with strong balance sheets and buying them when nobody else wants to buy them. That's all there is to it.

Follow these simple rules and a couple more and then sit back and allow reversion to the mean to work its magic. If our experience is any indication, it can lead to great wealth accumulation over the long term.

Good Investing,
Rahul Shah
Rahul Shah (Research Analyst)
Editor, Profit Hunter

PS: Apurva Sheth, editor of the Profit Hunter's premium newsletter, is not only confident that Sensex will hit 100,000 - but can tell you exactly which stocks will take it there. To read his brilliant report, click here to learn how you can access it.

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2 Responses to "The Magic Formula that Turns Ugly Ducklings into Beautiful Swans"

Srinivasan

Apr 17, 2018

By the same token should we expect your performance too to deteriorate in the near future after a streak of superlative performance??
Mean reversion, after all.
If it works for Sachin it will work for Rahul also. Law of average....another name to mean reversion.

Like (1)

Ananth

Apr 16, 2018

Regarding your quote " I learnt this brilliant idea from a fighter-pilot instructor who personally vouched for its effectiveness.

His own success rate using this trick had been amazing. Whenever he used to scream at cadet pilots for blunders, they usually did better. In contrast, whenever he praised them for doing well, they did worse on the next sortie."

Would recommend you read "the undoing project"(I dont know if the fighter pilot quote is inspired:) ). In essence scolding or praising are statistically insignificant factors which is the central point you are making.

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