The weakening force of mean reversion

The intellectual principles of ‘value’ investing rely on the interplay between mean reversion and behavioural finance. The theory goes that irrational levels of pessimism in ‘out of favour’ stocks drives down their share prices to levels well below fair value. Over time, as that excess pessimism dissipates, the shares should revert upwards towards the mean. The lesson being that you should buy low price-to-earnings (P/E) and/or price-to-book (P/B) multiple stocks as a signal of that disconnect to fair value. On the flip side, Graham et al. would preach that ‘hot’ stocks are plagued with over-exuberance, to the point that their price moves well beyond fair value. As reality hits, that bubble of optimism deflates and high multiples mean revert in a downward direction. 

“Reversion to the mean is the iron rule of the financial markets.”
John C. Bogle – Founder of Vanguard

Let’s get one thing straight from the outset. A low multiple stock is not necessarily cheap, nor is a high multiple one necessarily expensive. Traditional multiples are purely a signal of expectation. Whether they are cheap or expensive depends on the direction and magnitude of the disconnect between reality (fair value) and expectations (the share price). Every fund manager on earth is a value investor to some extent. We’re all trying to discover investments where a favourable disconnect exists. The only difference between managers who invest in low- or high-multiple companies is how mean reversion behaves; the former hoping that mean reversion DOES exist to drag up a low multiple, and the latter hoping that mean reversion DOESN’T occur to erode the growth and/or profitability of their investments. 

We’ve witnessed higher-multiple/expectation stocks tending to outperform their lower-multiple counterparts for a long time now, at least since the financial crisis of 2008 barring a few sharp rotational periods. Benjamin Graham’s interplay between mean reversion and behavioural finance has seemingly broken down. There hasn’t been a reversion to the mean and, moreover , the dispersion around the mean has increased significantly. 

Many argue that lower interest rates are to blame. Crudely speaking, ‘value’ investors tend to use  multiples such as P/E or P/B as a signal for value, the short-term nature of which doesn’t benefit from those lower rates. Conversely, wisdom goes that ‘growthier’ investors find marginal upside from lower discount rates in longer-duration valuation tools such as a DCF (discounted cash flow). I’ve only ever used an 8% cost of capital, so think it’s a bit of a fallacy that lower rates are needed to find compelling value in high-quality structural growth businesses.

For me, the principal factor in the dispersion between lowly- and higher-rated businesses is the weakening force of mean reversion. 

Concentrating on the ‘winners’ 

At the top end, high-quality growth businesses have evidenced more persistence than theory would suggest. Rather than succumb to the competitive erosion of free-market economics, they’ve managed to ‘beat the fade’. In essence, Buffett’s ‘moat’ of competitive advantages has widened. Scale is winning. Markets are becoming more concentrated. Factors such as technology, data, network-effects, brands, and innovation mean that profit pools are gravitating towards fewer and fewer winners. The handful of special companies that can stay ahead of competition through disciplined reinvestment and innovation have demonstrated a remarkable resilience and persistence that sits at odds with some investors’ expectations for mean reversion. 

At the other end, lower-quality and lower-expectation companies have suffered. All the dynamics that support the winners are working to undermine the losers. The strong get stronger, the weak get weaker. Disruption and disintermediation of business models has accelerated at an exponential rate. Businesses facing structural and competitive headwinds haven’t been able to fight against the tide. Mean reversion hasn’t been there to help because the pace of erosion has been faster than the market can comprehend. Reality has lagged even the bearish expectations of lowly-rated companies. 

What could end this dynamic? 

Well, either mean reversion would have to reassert its authority or expectations become so extreme as to price in its irrelevance. On the former; mean reversion’s greatest ally is regulation. Regulatory intervention that undermines the competitive advantages garnered by the winners would materially harm their persistence. Mind you, recent history suggests that capitalist societies have a poor track-record of enforcing healthy competition.  For the latter; if expectations continue to move in such polarised directions, then they could end up pricing in the absence of mean reversion. Quality could end up being priced for perpetual perfection, whilst the weak could be priced for absolute destruction. 

Where are we on that path? 

I think we’ve only just started to truly understand the power of both disruption and persistence. Many investors are hard-wired to think in a linear fashion, whilst disruption and technological empowerment tend to operate on an exponential curve. Our inherent caution pulls us back towards mean reversion. Average is comforting. Linear is comforting. Unfortunately, the current reality is a very different beast. Until mainstream valuation methods catch up with mean reversion’s decline, I think we’re going to continue to witness a market in which Benjamin Graham would struggle to outperform.