RE:RE:RE:RE:RE:RE:RE:To all prospective investors Cheap stocks earn outsized returns BECAUSE they are such awful companies. Investors over-react to bad news. Like all humans, investors are prone to well-known cognitive biases which are driving the prices of under-performing stocks below their intrinsic values. The Gambler’s fallacy describes how most people would extrapolate a trend into the future. A lucky winning streak is wrongly expected to continue well into the future, as will a negative streak. Many investors falsely believe that an underperforming company will continue to underperform into the distant future, while statistics show that underperforming companies tend to improve their results and thus revert to the mean. This fallacy causes the market to undervalue losing companies. The Loss Aversion fallacy, discovered by Daniel Kahneman and Amos Tversky, explains how humans strongly prefer to avoid losses than to acquire gains. Investors give too much weight to bad news, reducing the prices of distressed stocks below their intrinsic values.
When a company hits rock bottom, trading miserably cheap, massive forces come into play to turn it around. The first of such forces is the reversion to the mean phenomenon. Businesses that have performed below their industry’s averages tend to improve their performance over time, thus reverting to the industry mean. Over time and a given a large enough sample base of stocks, losers and winners will return to mediocrity, i.e., to the average performance of the group as a whole. Buy a large group of underperforming companies, and as a group, they are statistically likely to perform better as time passes.