Mean reversion (what really drive return) is the theory suggesting that prices and returns eventually move back toward the mean or average. This mean or average can be the historical average of the price or return, or another relevant average such as the growth in the economy or the average return of an industry.
A reversion involves the return of any condition back to a previous state. In cases of mean reversion, the thought is that any price that strays far from the long-term norm will again return, reverting to its understood state. The theory is focused on the reversion of only relatively extreme changes, as normal growth or other fluctuations are an expected part of the paradigm.
The mean reversion theory is used as part of a statistical analysis of market conditions, and can be part of an overall trading strategy. It applies well to the ideas of buying low and selling high, by hoping to identify abnormal activity that will, theoretically, revert back to a normal pattern.
The “asset-growth anomaly” can be viewed from the perspective of mean reversion. Mean reversion is not driven by the ebb and flow of animal spirits alone. Rather, it works through differential rates of investment. Companies which earn above their cost of capital tend to invest more, thereby driving down their future returns, while companies which fail to earn their cost of capital behave in the opposite way. This point is recognized by Benjamin Graham and David Dodd in Security Analysis (1934), the bible of value investing:
A business which sells at a premium does so because it earns a large return upon its capital; this large return attracts competition; and generally speaking, it is not likely to continue indefinitely. Conversely in the case of a business selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field, and other natural economic forces, should tend eventually to improve the situation and restore a normal rate of profit on the investment.
Investment drives mean reversion for both individual companies and whole markets. A researcher at the University of Arizona has demonstrated that corporate investment in most developed economies (comprising US and EAFE) is a significant negative predictor of aggregate profitability, stock market returns, and even GDP growth. During the US stock market bubble of the late 1990s, for instance, the investment share of GDP rose above average levels. After the bubble burst and the misallocation of capital of the boom years was revealed, both aggregate investment and profitability declined and the US economy went into recession.
To become an equity investor, you need three foundational elements:
- to tell a fundamentally strong company from one that is not based on it’s financial statements, it’s business model, and the dynamics of it’s industry
- to put those fundamentals in the context of the prevailing market price and how those prices are subject to variation based on swings in the nebulous concept called market sentiment, and
- to recognise, and protect against the potential influence of those market sentiments on our decision-making i.e. our susceptibility to behavioural biases when making investment decisions
These elements are common sense, but they take a lot of conscious effort (learning) to understand and even more effort to implement. Most investors aren’t able to.
Last but not least, fascinating over an old man, The Dean of Wall Street on Liquidations, Activism, and the Great Mean-Reverting Mystery of Value Investment – Quoted
Chairman: “. . . One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about—by advertising, or what happens?” Graham: “That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it in one way or another.” —Benjamin Graham, “Stock Market Study. Hearings Before
The Committee on Banking and Currency, United States Senate, Eighty-Fourth Congress, First Session on Factors Affecting the Buying and Selling of Equity Securities.” (March 3, 1955)