Mean reversion is a powerful force. It drives market cycles, stock prices, profit margins, earnings, growth rates…you name it.
Michael Mauboussin wrote a piece about it in 2007 based on ROIC. ROIC (Return on Invested Capital) measures the profitability of a company. Positive is good, high is better, persistently high is great. Here’s the gist of his piece:
Exhibit 5 shows one measure of persistence: the degree of quintile migration. This exhibit shows where companies starting in one quintile (the vertical axis) ended up after nine years (the horizontal axis). Most of the percentages in the exhibit are unremarkable, but two stand out. First, a full 41 percent of the companies that started in the top quintile were there nine years later, while 39 percent of the companies in the cellar-dweller quintile ended up there. Independent studies of this persistence reveal a similar pattern. So it appears there is persistence with some subset of the best and worst companies. Academic research confirms that some companies do show persistent results. Studies also show that companies rarely go from very high to very low performance or vice versa.
Before going too far with this result, we need to consider two issues. First, this persistence analysis solely looks at where companies start and finish, without asking what happens in between. As it turns out, there is a lot of action in the intervening years. For example, less than half of the 41 percent of the companies that start and end in the first quintile stay in the quintile the whole time. This means that less than four percent of the total-company sample remains in the highest quintile of ROIC for the full nine years.
The second issue is serial correlation, the probability a company stays in the same ROIC quintile from year to year. As Exhibit 5 suggests, the highest serial correlations (over 80 percent) are in Q1 and Q5. The middle quintile, Q3, has the lowest correlation of roughly 60 percent, while Q2 and Q4 are similar at about 70 percent.
There are three things to take away from the chart:
- A few good companies persistently stay good
- Some bad companies persistently stay bad
- The large majority of companies show reversion to the mean
Value investors, depending on their persuasion, mostly look for two of those three. GARP investors (growth at a reasonable price), like Buffett, want to buy #1 at a reasonable price. The more traditional value investors seek out #3 at a discounted price. And of course, the goal is to avoid #2, unless the price is so deeply discounted that it offers a high return but its margin of safety makes losing practically impossible.
What stands out is only 4% of the total companies tested defied mean reversion. They maintained their high profitability throughout the period.
Anyone attempting to replicate Buffett’s wonderful companies strategy is dealing with two difficult tasks. First, they have to find the elusive 4%. Second, they also must figure out whether the high profitability is already priced into the stock.
The risk is overpaying. If the market expects high profitability, then it’s already priced in, maybe to the point of being overpriced. They need the rare combo of high profitability but with low expectations priced in. That leaves them some room for error in case they’re wrong.
You don’t get paid for picking winners; you get paid for unearthing mispricings. Failure to distinguish between fundamentals and expectations is common in the investment business.
Another risk is being wrong about profitability. Where investors often go wrong is failing to expect mean reversion.
Investors that don’t understand this often end up overpaying for a stock. They buy high expectations thinking profitability will continue as it has or get even better. In other words, they fail to expect mean reversion. Instead, profitability reverts, expectations fall, the stock falls in price, and they sell at a loss, possibly thinking it continues to worsen. Where again, they fail to consider mean reversion.
Investors that do understand this, buy stocks with low expectations thinking it will turn out better than expected. It actually does. So profitability improves a little, expectations rise, price rises with it, and the investor sells at a profit.
The combination of reversion to the mean and investor behavior is what drives stock prices. The addition of behavior creates the condition for stock prices to overshoot. Prices become too high (too low) because expectations become too high (too low). Until mean reversion corrects it.
Death, Taxes, and Reversion to the Mean
- Why Are Some Companies So Expensive? – Verdad
- The Virtuous Investor: Laugh in the Face of Danger – Klement on Investing
- Where ESG Fails – Institutional Investor
- IPO Lessons for Public Market Investors – Musings on Markets
- Why New Technology Is A Hard Sell – M. Housel
- A Big Little Idea Called Ergodicity (Or The Ultimate Guide to Russian Roulette) – T. Pearson
- How Probabilities are Expressed Can Impact Our Investment Decision Making – Behavioral Investment
- Daniel Kahneman: Putting Your Intuition on Ice (podcast) – Knowledge Project
- Big Decisions: Michael Mauboussin Talks Luck and Skill (video) – Acquirers Podcast
- Marks Memo: Mysterious (pdf) – H. Marks
- How Baseball Cards Got Weird – The Atlantic