How reliable is reversion to the mean? Can we count on it to faithfully raise the price of the bargain stock we bought?
Michael Mauboussin said we cannot. In chapter 25 of "More Than You Know: Finding Financial Wisdom in Unconventional Places," he explained that while reversion is a real phenomenon, not all companies are positioned to take advantage of it.
He began his case with a question: “But what really determines a price-earnings ratio?” Then, he pointed out that a company’s value depends on both its growth rate and its economic returns. Thus, it can be misleading to look at growth in isolation.
What’s more, you should have a solid sense of whether a company is generating appropriate returns before you can judge the effects of growth. As he observed, “Companies can, and do, grow their way to bankruptcy.”
In turn, to get a sense of a company’s outlook for economic returns, you must understand its competitive strategy. The latter will depend on the answers to three questions:
- Are its returns on investment above the cost of capital? If not, could the company generate them later? (GuruFocus provides a helpful graph item called “WACC vs. ROIC” (Weighted Average Cost of Capital vs Return on Invested Capital.))
- If returns are higher than the cost of capital, how long can these excess returns be sustained?
- If returns are lower than the cost of capital, what is the probability the company can put together a sustained recovery to earn excess returns?
Mauboussin noted that he planned to take up questions two and three in the remainder of the chapter.
First, he addressed the theory that a company’s returns on investment revert to the cost of capital over time. It’s based on the premise that companies with high returns attract competition and capital, and eventually drive returns toward the level of opportunity costs. On the other hand, companies and industries that have poor returns see an exodus of capital (bankruptcy, disinvestment, consolidation) and eventually their returns rise back to the cost of capital.
The following chart shows how a sample of 450 technology companies fared between 1979 and 1996 (before the internet bubble). The companies are ranked by cash from return on investment, which uses after-tax and after-inflation measures:
The best-performing group started with a CFROI of 15%, but declined to 6% within five years. During the same period, the worst group zoomed from -15% to nearly zero (much better, but still below the cost of capital). Mauboussin added, “While 10 years is insufficient to complete the reversion-to-the-mean process, much of the progression is evident within that time frame.”
Attribution was behind most of the improvement among the worst performers, with just 60% of them still surviving after five years. And, over the five years, attribution rates generally averaged out.
A study of nearly 700 retailers, between 1950 and 2001, showed that only 14% of companies managed to keep returns from falling below their cost of capital. That’s important; as Mauboussin noted, “Sustaining high returns is a huge potential source of wealth. Given two companies with the same initial returns and future growth rates, the business that can sustain above-cost-of-capital returns longer will be significantly more valuable and hence will trade at a much higher valuation multiple.”
But what about the companies that stumble and fall? More technically, what about companies that experience two consecutive years where CFROI is less than the cost of capital, after two years of returns that beat the cost of capital?
Stocks that do that are likely to catch the eye of value investors, but experienced investors will know that some are temporarily in trouble, while others are cheap for a reason. He added:
“Stock prices reflect expectations, and the key to generating superior long-term returns is to successfully anticipate expectation revisions. An important corollary is that neither a good (i.e., high-return) business nor a bad (low-return) business is inherently attractive or unattractive. Investors need to assess the stocks of all companies versus expectations.”
And what should you expect, overall, of companies that fail to meet their cost of capital for two years? According to the two studies cited in this chapter, there was just a 29% probability that a company would have a sustained recovery. Just under half managed no recovery whatsoever, while roughly a quarter had what was called a “nonsustained turnaround”.
As Mauboussin put it: “Companies can disappear gracefully (get acquired) or disgracefully (go bankrupt).”
The research also found that downturns were relatively short for both tech and retail stocks. About 27% of them lasted two years or less, while 60% lasted less than five years.
He made two complementary conclusions:
- This research underscores the strength and consistency of competitive forces. Most bargain stocks are cheap for a reason, and the probability of earning a sustained return above the cost of capital return is low.
- Still, almost 30% of companies did make a recovery, which Mauboussin said was evidence that value investors have an opportunity to earn above-average returns if they have “a strong grasp of competitive dynamics and a sufficient time horizon.”
Conclusion
In chapter 25 of "More Than You Know: Finding Financial Wisdom in Unconventional Places," Mauboussin dug into one of the basic tenets of value investing: that good quality, underpriced stocks would recover and outperform, thanks to the mean-reversion phenomenon.
As we saw, reversion to the mean does exist and does work. But it doesn’t work for all stocks, all the time. In the case of technology and retail stocks in the second half of the 20th century, it worked less than a third of the time.
More broadly speaking, reversion to the mean may reflect survivorship, as attribution pulls underperformers toward the mean and competitive forces push outperformers toward the mean as well.
GuruFocus 15-year anniversary promotion
The holiday season is here, and so is GuruFocus’s 15-year anniversary! In order to celebrate, we are offering an exclusive holiday discount of up to 30% off on our GuruFocus Premium Membership.
Join now to get GuruFocus Premium membership for only $399/Year! In addition, save an extra $100 when you upgrade to our PremiumPlus Membership, and enjoy $100 off the price of each additional region you add to the subscription.
Don’t miss out on this once-in-a-decade deal! You can sign up for the discount price by clicking this link. Happy holidays!
Read more here:
