Growth Portfolio and American Growth Portfolio Commentary
Mean reversion is constantly working in the background of our everyday lives, responsible for everything we consider to be normal. It describes how things evolve over time towards a long term average value. It’s important because it’s a primary driver of the long term risk and return of investment portfolios.
For a simple example of how mean reversion works, we can look at height. If you’re a tall person, it’s likely your children are also tall, but not as tall as you. Your children’s children might be tall, but are more likely average height. Mean reversion balances out all the tall and short people over time towards an average height. It turns out nature wants just about everything to fluctuate around an average.
The idea is deceptively simple. “Simple” because we all intuitively understand how this process works, but “deceptive” because our behaviour does not always match our understanding.
Two finance professors, analyzed how 3,700 retirement plans, endowments and foundations hired and fired investment managers over a ten year period (1). They found that the institutions tended to hire new managers that had outperformed the market over the prior three years. The number one reason they fired managers was poor recent performance. Consistent with reversion to the mean, the professors noted that in subsequent years, many of the fired managers went on to outperform those who were recently hired.
Individual investors show similar behaviour. Research firm Dalbar found that most investors consistently buy stocks in hot markets and yank money out after a drop (2). That buy high, sell low behaviour is why the average equity investor earns about 50% less return than the S&P 500 over time. In professional and individual cases, ignoring mean reversion substantially limits long term return.
The downside of mean reversion is clear, but what about the upside?
In a seminal paper published in 1987, professors Debondt and Thaler showed that companies with higher than average earnings today tend to earn lower returns in the future, and companies with lower than average earnings today tend to earn higher returns in the future (3). This surprising result confirms a fact that’s confounded investors for decades: the largest returns come from companies recovering from lower than average earnings.
A real life example of mean reversion was recently brought to my attention over lunch with Mike Philbrick from Resolve Asset Management. In June 2000, going into the peak of the tech bubble, Warren Buffett’s Berkshire Hathaway had underperformed the S&P 500 by 60% over the prior two years. Buffett was down 31%, while the S&P was up 28%. Just about everyone thought he lost the magic touch. This 1999 article from Barrons might be one of the best foot-in-mouth lessons ever recorded: http://www.barrons.com/articles/SB945992010127068546. Two years later, in June 2002, Berkshire Hathaway was up 24% while the market was down 32%. Four years later, Berkshire was up 65%, the market still down 22%.
Buffett was not the only one riding the mean reversion wave. The chart below is from investment firm Euclidean Technologies (4). Euclidean came to the same conclusions we did in our February Commentary about expectations for value strategies. Their chart illustrates what’s happened to value investment strategies following periods of underperformance. The results speak for themselves -- Buffett is not an outlier.
The evidence is clear: the higher the current performance of an investment strategy, the less we should expect over the future. And the lower the current performance, the more we should expect over the future.
So where does that put us today?
After a huge rally in Canadian banks and energy companies, top performers by a country mile, the TSX Composite Index is vulnerable to mean reversion. The top ten companies in the TSX are mostly banks and energy, accounting for 40% of the total weight of the Index. Those companies are trading within 93% of their highest valuations of the last ten years.
We can take a closer look at Royal Bank as an example. Royal is the largest company in the TSX, making up 7% of the Index, and currently trades at about 14 times earnings. That puts Royal within 91% of its highest valuation of the last ten years.
In the chart below, I’ve illustrated Royal’s share price in the top pane, and Royal’s price-to-earnings (PE) ratio in the bottom pane. You can see that levels above 13.75 times earnings (red circles) have reverted to the mean in the past. Five instances record an average subsequent share price decline of 21% (the average of the red boxes). Other banks show similar histories.
The chart is visually compelling, however we can’t rush to conclusions. Nothing is carved in stone preventing a fully valued company from becoming even more fully valued before mean reversion takes hold. Although we can always count on reversion, its timing can be unpredictable over the short term. That said, when faced with a choice between owning a fully- or under-valued company, sensibility sways me to the latter.
The TSX appears fully valued, but perhaps Canada’s biggest fund managers are positioned differently?
Surprisingly, two of the largest mutual funds in Canada have invested even more client money in banks and energy than the Index. One fund has 38% in financials and 22% in energy, while another has a whopping 63% in financials and 13% in energy. It turns out that many popular Canadian mutual funds and ETFs are concentrated along similar lines. So much for diversification…
Economist John Maynard Keynes said it is better to fail conventionally than to succeed unconventionally. I’m not so convinced.
The reputation of the Growth Portfolio is staked on independent thinking, deep research, and ignoring the investment beauty contest. I believe that’s what makes our investors more level-headed than the average. We zig when others zag, looking for opportunities ripe for reversion. Yes, we end up kissing some toads along the way, but we meet more than our fair share of princes.
Independent thinking, especially when it’s producing less than average short term results, is difficult. The patience required can make me look wrong, dumb, stubborn, and sometimes all three. The truth is I am far more comfortable relying on a proven long term value approach and putting up with periods of lower than usual performance than I am chasing hot stocks into near-record valuations with your wealth.
Sometimes that means Index investments and other funds will produce brighter and more exciting flashes of return than us from time to time. That’s ok. Mean reversion is a far more powerful corrective force in the long run.
Income Portfolio Commentary
We’ve spent the last several months adjusting towards a more neutral position relative to income portfolios held by other Canadian investors. Our conservative focus on reducing risk has meant our performance has lagged in relation to many popular funds over the past year. While still producing a very decent return of just under ten percent on the year, I see other income funds showing in the twenties – a strange, rare, and somewhat concerning sighting. Most dividend-focused funds find themselves today making concentrated bets on just two fully-valued sectors of the Canadian economy (financials and energy) that have demonstrated considerable cyclicality in the past. That type of cyclicality is what we’re trying to avoid in managing long term capital for our investors.
Our systematic approach is telling us that capital preservation is a more worthwhile goal near-term goal than chasing return. We are far more diversified than most Canadian income investors, both by geography and sector, which provides good comfort.
We will continue to manage the Income Portfolio to preserve capital, grow conservatively and reduce risk.
The roots and causes of human irrationality: http://www.newyorker.com/magazine/2017/02/27/why-facts-dont-change-our-minds
Some interesting properties for sale in Toronto these days: https://twitter.com/RobynUrback/status/834426411687542784/photo/1
As always, please let me know if you’d like to chat about financial planning, long term investing, and other investment opportunities.
Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Altus Securities Inc.
55 Yonge Street, Suite 1100