I often refer to the tendency for prices, valuations, and other investment metrics to ‘revert to the mean’. When I do, I’m usually talking about the ratio of house prices to earnings; the cyclically adjusted price/earnings (Cape) ratio of a market; or corporate profit margins in the US.
They are all things that, over time, hang around a noticeable average. When they move to an extreme from that average, they tend to move back again.
But just because whole markets have a tendency to revert to a mean valuation doesn’t mean that everything does.
I’ve been looking at a report on this from Mark Urquhart, one of the indefatigable optimists at Edinburgh based Baillie Gifford (I am on the board of one of its investment trusts). According to him, the four most dangerous words in investment are not, as most of us think, “this time, it’s different”. They are “reversion to the mean”.
When it comes to individual stocks or sectors, he says, the idea that prices will return to some kind of average assumes that the “external environment remains the same over time”. But, he argues, it doesn’t. Instead, we are living in a period of exceptionally rapid change – change that can have “profound effects on equities”.
Take the way Urquhart satisfied himself with the definition of reversion to the mean. He looked it up on Wikipedia, a website now accessed by 15 per cent of internet users every day, and viewed by pretty much everyone as the starting point for researching anything. Just 12 years ago, Wikipedia didn’t exist.
Then look at our high streets. Twenty years ago, the regional press and speciality retailers were deemed to be good investments. So much for that: the internet has utterly destroyed the business models of both – making fortunes for the founders of the likes of Google, Facebook and Zynga (a social gaming company) along the way.
Here, the point is obvious but it is still worth making: some things don’t revert to the mean, they just go to zero.
This thought is also taken up in a recent paper from Nick Train of Lindsell Train (I know I mentioned him last week, too, but I promise it is just a short-term crush).
He notes that, in 1892, it cost $9 for a five-minute phone call from New York to Chicago. Today, if you can figure out how to use Skype, it is free. There probably isn’t going to be a cyclical upswing back to the average price of a phone call.
Set too much store by reversion to the mean and you will be “routinely tempted to sell out of long term winners and into clunkers . . . this is not an obvious winning investment strategy”.
All of which brings me to the clunkers of the week: UK banks.
A good many people think you should buy their shares. They look at how the financial crisis and, more recently, the hounding of Bob Diamond has pushed prices down across the sector. Compared with their historical price/earnings or price-to-book ratios – or just about any other measure you care to mention – they are not so much cheap as practically free.
That’s true. They are.
But history doesn’t tell us everything. In some cases, such as this one, it tells us nothing at all.
The banking business model of the past couple of decades (taking advantage of leverage, abnormally low interest rates and light-touch regulation to make managers rich and shareholders poor) is not a model that will be allowed in the next decade.
There is going to be significantly tougher regulation. There is going to be intense public scrutiny. There are going to be all sorts of new entrants to the market – witness the peer- to-peer lenders I wrote about a few weeks ago and the number of companies issuing bonds directly to investors.
There will also be changes to managerial incentives.
All of that suggests the banks are virtually guaranteed to make lower returns in future and should command much lower valuations as a result – well below their old mean.
If you want to invest in companies for whom the business environment is improving rather than collapsing, you might instead look to some Baillie Gifford favourites in the US: companies such as Illumina, the world leader in genome sequencing technology and Intuitive Surgical, the leader in robotic surgery. Both are held by the Scottish Mortgage Investment Trust.
• A few weeks ago, I wrote that while property in much of Europe is starting to look cheap, further tax rises will mean that the upfront price is only the beginning of the cost. This is increasingly going to be the case in France, where François Hollande, the president, has just announced a tax grab on holiday homes. The income tax take on rentals is to rise from 20% to 35.5%, and the capital gains tax on sales is to rise from 19% to 34.5%. Yet another reason to rent rather than buy.
• This article was first published in the Financial Times