Most people like to think that they’re contrarians when they’re buying companies that face an earnings result that missed expectations but the more accurate approach isn’t being contrarian but actually just being a mean reversion trader.
The fact is that high quality stocks disappoint. Eventually, companies will have a harder time reaching or exceeding investors’ expectations mainly due to the bars being set high.
That’s why mean reversion traders and investors love buying high quality companies that miss earnings results. They are the ones who know that the correction is a cyclical effect and not a structural one. These traders aren’t ordinary small time investors. These are deep pocketed traders who know that a highly profitable business will have a mean return equivalent to its historical growth rates. The higher the margin of safety, the less obstacles when it comes to exceeding expectations over the succeeding months and quarters.
Note though that a bad business model can never be cured by cheap valuations.
The business in itself has to have high cash flows to make it really desirable amongst value investors. Its operating income must be recurring (delete the one-off gains especially in financial firms). The company must be earning at least 18% on the invested capital (ROIC.) That’s a superior business.
Make it a habit to find good businesses having a bad day and you’ll be fine.
Hence, it would be super wonderful should our market correct in a manner that is decisively huge since that would offer you one of the best entry points simply due to cyclical and timing issues of acquisitions that haven’t resulted to earnings growth but will deliver so within a few years.
This approach though is not for everyone.
These will not work for people with a time horizon of less than three months.
– Faceless Trader