Newsletter March 29, 2008
InvestorsFriend Inc. Newsletter March 29, 2008
“Regression to the Mean”, “Return to the Average” or “Return to the Trend”
One of the most important concepts in investing is called “regression to the mean”. More descriptively I like to call it “return to the historical average” or “return to the trend”.
Many variables in the economy tend to fluctuate but over very long periods of time tend to return towards their historical mean or average value. Such variables include interest rates, inflation, unemployment rates, corporate profits as percent of GDP, price to earnings ratios and many more.
The concept of regression to the mean or return to the average suggests that if one of these variables is substantially above or below its historical average level, then there will be some tendency for the variable to move back towards the historical level. There is certainly no guarantee that this will happen and even if it does it could take decades. Still, the concept is useful as a reminder that assuming that a particular variable will stay well above its historical mean can be a very dangerous assumption.
I use this concept in valuing stocks. If a stock has a P/E of 30 today, I always assume in my valuation work that this P/E is going to trend down towards some market average such as 15 if the stock is held for 5 or 10 years. I don’t assume every stock will trend all the way to 15. But I do consistently assume that a high P/E stock is going to trend somewhat lower. I am seldom if ever willing to assume that any given stock will have a P/E higher than 20 five years from now. (And usually my assumptions are more in the range of 15 to 18).
This concept is also very useful in thinking about the trend in a stock market index or an index of housing prices. An “index” is the record of historical prices over a long time period. Indexes include stock market indexes like the TSX stock index or the S&P 500 index. Long-term price indexes are also available for commodity prices, average house prices and many other prices.
The concept of regression to the mean or return to the trend suggests that over the long term every price index tends to grow (or in rare cases decline) at some average rate. In the long-term the index is usually trending up at some rate. Regression or return to the trend says that if the growth gets well ahead of the trend for several years then you can be reasonably sure that the growth in the index will slow down or go negative so that the index will, in the very long term, continue to grow at or close to its long-term trend.
For example the S&P 500 index has trended up at a long-term average rate of 5.6% per year in the 100 years from 1907 to 2007. (The return on stocks was higher than that with dividends added in, but the stock index trend has only been 5.6% per year.)
For about the 14 years that ended in August 1982, the S&P 500 index meandered around but failed to grow over that entire long period. With 14 years of growing at an average of about 0% the index fell well below its long-term growth trend. It then played catch-up in a major way by rocketing up an average of 15.6% per year over the next 18 years. That was regression to the trend in action.
But, oops, the market grew so fast for so many years that by August of 2000 it was now well above where it should have been based on its 5.6% long-term growth trend. Regression to the trend finally kicked in again and the market sank like a rock and even today is below its August 2000 peak.
Any price trend whether it be houses, stocks or gold that gets very much above or below its long term trend will likely at some point reverse course in order to return towards its long-term trend.
However, any market can remain above or below its long-term trend for many years and so regression to the trend is not a way to predict markets in the short-term. The long-term trend growth level can also change over time.
Refinements of this concept can include looking at the inflation-adjusted or real trend rather than the trend in normal inflation-affected dollars. It may be that the real trend is more constant over time while the nominal trend is less stable.
Regression to the trend or mean is far from a precise indicator. But it certainly can be a warning sign. When house prices jump 200% in a few short years, it really should not surprise us when they then fall for a few years to get back closer to the long-term trend.
Warren Buffett suggests that investors should focus their investments in companies with a competitive advantage.
Companies with a competitive advantage make higher profits. Logically, it is easier to make a good return by owning a company that is making high profits rather than low or negative profits. You can make high profits (from other investors) in loser companies by smart trading. But in winning companies, it is much easier to make money. All you have to do is buy the company (at a reasonable price) and then simply go along for the ride as it makes profits from its customers. You won’t have to worry so much about making profits from smart trading with other investors if you can simply sit back and enjoy the profits flowing in from customers of the businesses you own.
The following are some of the more important categories of competitive advantage
Some companies like Wal-Mart and Costco have cost advantages. These can come from superior operating strategies or simply from scale advantages. The largest company in an industry can negotiate for the best prices from all its suppliers. It also has scale advantages internally. (One accounting system for 10,000 stores is simply more cost-effective than one accounting system for three stores). It then becomes difficult for a new competitor to ever achieve the low costs of a large incumbent. (Unless the incumbent becomes fat and lazy like a GM or a Sears did).
PATENTS AND OTHER GOVERNMENT-GRANTED MONOPOLIES
A drug company with a patent on a popular consumer drug can certainly make huge profits. Governments have given monopolies to doctors and dentists. Dentists can make large profits partly because their industry association insures that they (for the most part) do not compete on price. They also tend to use supply management to limit their numbers.
CUSTOMER SWITCHING COSTS
In some industries, once a customer is acquired, the customer faces high switching costs (in time and or money) to change suppliers. Think of the hassle that is involved to change to a new cell phone company (particularly in the days before number portability). Or the hassle involved in changing your main chequing account to a new bank – you have too many pre-paid items. Similarly with credit cards, you may have some automated payments coming off your credit card each month and it then becomes a hassle to switch credit cards. Life insurance – you may need a medical exam. Even if you are sure you are healthy, who wants the hassle of a medical exam just to switch life insurance companies?
Have you noticed how your property insurance company has wanted to bundle your car and home insurance? Now it becomes difficult to get a comparable quote from another company because there are so many variables in your insurance policies.
Consider tax preparation software. Who wants to switch to a new software when if you stay with the same one it will read your tax return from last year and that will cut down on what you need to enter.
And consider industries where you can switch suppliers easily like Air lines and grocery stores. These tend to be lower profit industries.
Related to customer switching costs is difficulty in comparing costs. Certain financial products are pure commodities. And yet they do not appear to always compete aggressively on price. The incumbents tend to not make it very easy to shop around for the best price. The best mortgage rates at many banks are not posted.
In certain industries like on-line auctions (eBay) and on-line payments (PayPal), software (Microsoft Windows, Excel and Word) and Stock Exchanges, all consumers tend to be attracted to the largest player.
In auctions and stock markets all sellers want to use the system with the largest number of buyers. Similarly the buyers want to be where the sellers are. Once e-Bay popularized on-line auctions and grabbed a big market share, it became very difficult for any other company to crack that market. Basically it is a natural monopoly. The same applies, I believe, to the Toronto Stock Exchange.
Once most businesses started using Microsoft excel, it became convenient for other business to join in and use that same software. For many years it was clear that Windows was not the best PC operating system but the fact that most people were using windows simply made it inconvenient for users to switch. They needed to use what their suppliers and customers in their network used.
Another example is the two biggest credit card companies Visa and MasterCard. Merchants will only accept a few credit card types. This area became a natural duopoly, not surprisingly both of these companies make huge profits.
Many consumer products thrive on brand loyalty advantage. Partly this is also scale in that a dominant brand can advertise more efficiently. Consider franchises like Tim Hortons or Boston Pizza. They can open a new location and be guaranteed a customer base will instantly flow to their doors. Compare that to an independent unknown family restaurant that opens up. Other than friends and family it can be extremely difficult to attract customers.
Consider rail roads. There are only two in Canada. They have cost advantages over trucks for long-haul. It’s hard to imagine that any new entrant would ever be able to secure the land and City corridors that would be needed to build a third rail road in Canada. Not surprisingly they have been highly profitable, at least in recent years.
None of the above competitive advantages are fool-proof or ever-lasting. But most of them have a habit of enduring for many years. In selecting companies to invest in it makes sense to think about their competitive advantages regarding the categories above. If a company does not have a competitive advantage, how is it going to make above average profits? And if the company does not make above average profits, how will you as a shareholder make an above average rate of return in the long run?
Note: Subsequent to this article I came across a book that explains competitive advantage in more detail. It’s a small book, easy to read and contains a wealthof very valuable information.
You can order it here:
For free shipping on Amazon you will likely need to order a couple of books. Here is a link to my favorite investment books.
I can’t claim any special ability to predict where markets are headed. On the one hand by some measures such as P/E ratios the markets seem reasonably valued. On the other hand Warren Buffett has pointed out that corporate profits as a percent of GDP are well above their historical average. Therefore regression to the mean would suggest corporate profits can fall even if GDP keeps rising. Unemployment levels and interest rates are below historical averages and may therefore trend higher.
Housing prices are very much above where the long term trend suggests they should be. They could easily continue to fall. This could continue to wreak absolute havoc on financial institutions and could drive the economy into recession.
Overall, I think markets remain dangerous in the short term. But there are always some stocks that will do well in this environment. Such as those with strong competitive advantages.
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Shawn Allen, President
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