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.