Forget American politics and read this: 3 tips for Australian investors, Pt. 2

“The four most dangerous words in investing are: ‘this time it’s different.'”

— Sir John Templeton

Yesterday I shared the first tip for navigating today’s turbulent political environment: know your financial identity.

Today’s tip builds on that foundation.

Pay attention to the cycle.

Just as the cycle tends to repeat itself in politics, the same can be said about financial markets.

This isn’t about timing the market perfectly or predicting the next recession, because frankly, nobody can do that consistently.

Instead, it’s about understanding one of the most reliable forces in financial markets: mean reversion.

It can be thought of in an Adam Smith way as the “invisible hand” that guides financial markets.

Mean reversion is a financial theory that suggests asset prices will eventually return to their long-term average over time.

Think of it as the invisible hand that gently pulls extreme valuations back towards reality.

When an asset’s price deviates significantly from its historical average, there’s a higher probability it will move closer to that average in the future.

The greater the deviation, the stronger the gravitational pull back to normal.

Consider what’s happening right now in the Australian stock market.

After years of being ignored, dismissed, starved of capital, our micro and small-cap companies are showing signs of life.

And it’s trickled down faster to small-caps than micro-caps.

(For reference I think of micro-caps as sub $200M companies and small-caps as sub $2BN companies).

The great rotation looks like it is underway

Here’s a chart I shared with readers of Fat Tail Micro-Caps recently:

In the last month through to September 8th, the ASX Emerging Companies Index [XEC] had tacked on nearly 13% while the ASX 200 [XJO] managed a mere 2.2% return.

I use XEC as a rough and ready benchmark for micro-cap performance, and let me tell you, it’s been a while since I’ve seen this kind of miles ahead outperformance.

Let’s look at the last three years of data:

This is mean reversion in action.

Micro-caps have been out of favour for what feels like an eternity.

While the big end of town enjoyed the spotlight, these smaller companies were left trading at depressed valuations.

Cycles within cycles

What makes mean reversion so fascinating is that it operates across different timeframes and asset classes simultaneously.

We see it in individual stocks reverting to their average valuations.

We see it in sector rotation, where out-of-favour industries eventually regain investor attention.

And we see it in the eternal dance between growth and value, large caps and small caps, momentum and “quality”.

The research is clear: after prolonged periods of underperformance, asset classes tend to snap back with remarkable force.

Think about what investors witnessed during the early 1980s in the US, when small caps delivered annualised returns of 35.3% versus 15.7% for large caps over an eight-year period. That wasn’t sustainable forever, but investors who positioned themselves correctly at the beginning of that cycle were generously rewarded.

Why most investors miss the cycle

Here’s the psychological trap most investors fall into: they extrapolate recent performance into the future.

When micro-caps are getting hammered year after year, the natural human response is to assume they’ll keep getting hammered.

When large caps are flying, we assume they’ll keep flying.

But markets don’t work that way.

Mean reversion suggests that today’s laggards often become tomorrow’s leaders, and today’s winners eventually become tomorrow’s laggards.

The challenge is that these cycles can take years to play out.

The practical application

So how do you use this knowledge?

First, resist the urge to chase last year’s winners.

When everyone is piling into the same sectors or asset classes, that’s often a signal that mean reversion is about to work its magic in the opposite direction.

Second, keep an eye on valuation extremes across sectors.

Third, remember that mean reversion works best when combined with careful analysis on specific companies.

Not every beaten-down stock deserves to revert to the mean, some deserve their fate.

The current opportunity

Right now, Australian small-caps and micro-caps are presenting exactly the kind of setup that mean reversion theory predicts should work.

After years of underperformance, with many quality companies trading at deep discounts to their historical averages, the stage is set for a potential sustained reversal.

This doesn’t mean every micro-cap (or small-cap for that matter) will soar, but it does suggest to me that the probability of outperformance has shifted meaningfully in favour of smaller companies.

It looks like the cycle is turning, and smart money is starting to take notice.

This flows through to the capital available in the market to support small-caps and micro-caps.

This capital lives within companies in something called capital structure.

Tomorrow, I’ll share the third tip for Australian investors and show why understanding capital structure is so important.

Don’t know what capital structure is?

Stay tuned for that.

Warm regards,

Lachlann Tierney,
Australian Small-Cap Investigator and Fat Tail Micro-Caps