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Mean Reversion

Over time, a company establishes a mean return on capital (ROC).  Boom times and tough times will cause profitability to fluctuate, but competition causes ROC to revert back to the mean.

  • When an industry is booming, ROCs are well above average.  Companies expand as they plow profits back into the business.  High profits also attract new companies to the lucrative market. Price wars and over-expansion then ensue as these companies vie for more market share.  This increased competition eventually leads to lower prices and excess supply which eventually drives ROC and profits downward.
  • When an industry is going through tough times, ROCs are lower than normal.  Companies are forced to cut costs and become more efficient.  They get rid of excess capacity and some just plain exit the business all together. The remaining companies have become leaner, and there is now less supply in the market.  Prices can now stabilize or perhaps increase.  ROCs move upwards to a more normal level.

Reversion to the mean goes hand-in-hand with our value discipline.  We love to invest in companies that trade at a low valuation and have an ROC below its normalized return if our research points to an imminent turnaround.  It means we get to buy a stock trading at a discounted value to depressed earnings.  When things turn around, our clients get rewarded by great returns.