Mean reversion

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Woodford glossary

Mean reversion refers to the gravitational pull on an asset’s valuation towards its historic average.

For example, let’s assume that the long-term average valuation of a particularly stock, in terms of its price/earnings ratio (PE), is 15x. In other words, on average, the price of that stock is 15x that of its earnings base. That average would consist of long periods when the stock has been cheaper (with a lower than 15x PE) and long periods when it has been more expensive (with a PE higher than 15x).

The concept of mean reversion suggests that, ultimately, that stock’s valuation should gravitate towards its mean. In turn, the concept suggests that if you bought the stock when its valuation was below average, you would eventually benefit from an increase in its valuation towards the mean. Conversely, if you bought it when the valuation was above average, you will likely experience a valuation decline, eventually.

The concept isn’t bullet-proof, of course. It assumes that what happened in the past will prevail in the future which is clearly not always the case. The process of mean reversion can also take years, if not decades, to complete. But it can be a powerful force for patient, fundamentals-based investors to exploit.

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