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
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
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
Warren Buffett suggests that
investors should focus their investments in companies with a competitive
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
PATENTS AND OTHER
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
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
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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