Mean reversion is the phenomenon observed by economists which suggests that prices and returns eventually move back towards the median (or average) return for a given asset class. Put simply, the theory implies that any asset class will tend to replicate the average return for that particular asset class when tracked over an extended period of time.
In the case of stocks, the theory of mean reversion indicates that most large-cap stocks should, over the long-run, mimic the average returns of the S&P/ASX 200 Index (ASX: XJO).
Recent examples
Losers
To put this concept into practice, it is arguable that the theory of mean reversion is a reason behind the recent plunges in share price of Bellamy's Australia Ltd (ASX: BAL). Sirtex Medical Limited (ASX: SRX) and Vocus Communications Limited (ASX: VOC).
Each of Bellamy's, Sirtex and Vocus were market darlings in 2015 after experiencing years of blockbuster growth and market-beating capital gains. However, a slowdown in earnings and growth prospects for the trio makes them contenders for the biggest losers of 2016.
With shares in Bellamy's, Sirtex and Vocus each down over 50% since June 2016, economists would argue that their respective share price corrections was just a matter of time. Given the above average growth rates of each company, the theory of mean reversion, at its most basic level, suggests the trio is likely to undergo a period of underperformance and therefore they are stocks I'd stay away from today.
Winners
On the flipside, the theory of mean reversion also suggests that stocks which have underperformed the market for an extended period of time are more likely to outperform in the short-term. A prime example of this in the current year would be iron ore miner Fortescue Metals Group Limited (ASX: FMG), which has surged a whopping 220% since the start of this year on the back of improving iron ore demand.
What should you do?
Although mean reversion isn't the only reason behind Fortescue's impressive rebound, it does add to the statistics which substantiate the theory. Accordingly, if you're a believer in the notion it would be wise to look for stocks which have underperformed in recent times.
In my mind, the best place to go shopping for these types of stocks is the retail sector where returns have lagged for many years due to anaemic demand (and increased competition) in the sector.
Woolworths Limited (ASX: WOW) and Myer Holdings Ltd (ASX: MYR) are my top picks in this space, given their recent uptick in sales growth and medium-term underperformance in share price. Accordingly, investors looking for the next stock to benefit from this theory should start their research with these two.
Foolish takeaway
Investors must remember that mean reversion is just a theory. Therefore, like any theory, investors may tend to use confirmation bias as a means to justify random fluctuations in share price.
Admittedly, the cause for share price fluctuations in Bellamy's, Sirtex, Vocus and Fortescue this year can be explained by company performance and market conditions. However, economists may have you believe the changes are partly attributable to the philosophy of mean reversion.
Though this hypothesis cannot be ignored, savvy investors should use the theory to assist with buying companies that are growing, but underperforming the market. That is, investors should look to buy companies which are fundamentally sound, but are yet to be priced for their potential.
