Today I read an interesting quote from the Chinese classic Tao Te Ching: “Reversal is the way of the Tao.” (Chapter 40; other translations of the same passage are: “The motion of nature
is cyclic and returning”.)

When applied to investing, this ancient wisdom from the Tao Te Ching, could read: “Reversal is the way of the Markets.” What seems clear is that Markets in general, and businesses, in particular, go to extremes, from which they tend to reverse. Big losses many times lead to big profits, while big profits invariably pave the way for losses.

Investment is the art of spotting these extremes and betting on a reversal, when appropriate (some businesses, of course, never reverse).

The difficulty in investing is two-fold: Spotting the correct extremes to bet on and predicting the timing of a reversal.

In terms of spotting the correct extremes, I think the situation is somewhat simple. The key is obviously to investigate “losers”, and look for factors that promote corporate survival (i.e. the balance sheet, business credibility/stability), while at the same time searching for factors that may lead to growth (i.e. the “hype” factor). Both of these factors imply long-term demand for the shares.

Predicting the timing of a reversal, is a different matter entirely, and something which with time, I’ve come to realize is simply impossible. To make money you must be early, so in essence any good investor will lose money initially when betting on a reversal.

Nevertheless, there are some clues, I’ve found to be useful in spotting a potential “upside” reversal. These include, but are not limited to,: a big writeoff, a stock price at multi-year lows, a change in management/strategy, a divestiture, debt/balance restructuring or refinancing, a lack of analyst coverage, and a mismatch between cash-flow and income statements. Some of these clues can show up together, while at other times they surface independently. Often times, a major positive reversal as evidenced by the financials (i.e. a company moving from heavy losses to cash-flow positive results, e.g. VG), is completely ignored by the Markets for one reason or another, providing a nearly risk-free investment situation. Interestingly, a major acquisition or spurt of merger activity, is often a clear signal that a formerly successful company is about to reverse, in a negative sense.