HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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July 21, 2020

You Cannot Depend on Mean Reversion

“So we can usefully think of two economic regimes or worlds: a bulk-production world yielding products that essentially are congealed resources with a little knowledge and operating according to Marshall’s principles of diminishing returns, and a knowledge-based part of the economy yielding products that essentially are congealed knowledge with a little resources and operating under increasing returns”.

BRIAN ARTHUR

Loser Now

Mean reversion is a statistical theory that supports the investment in lowly valued assets in the same way that it makes sense at the beginning of the football season to bet on all the lower ranked teams from the prior season. Bob Dylan summed it up by singing, For the loser  now will later to win, For the times they are a changin’. The theory suggests that different financial assets will revert to a long run average over time. So buy low now, wait  for mean reversion to take hold, and then sell high, later.

Great Idea That Failed

Value investing, as it is known, has some compelling logic to it, however it has fallen out of favour in recent years as the returns the style has generated since the early 2000s have been disappointing. The evidence is that companies that are on low ratings (either PE or price to book measures) tend to remain locked into this category for longer than they have historically. Turned on its head, highly rated companies have tended to remain highly rated with the last big reversal in the 2001/3 dotcom crash, nearly 20 years ago.

Accounting for Change

There is quite a bit of controversy as to why this has happened, but in essence there have been several factors that have prevented the normalisation of returns across lowly valued and more highly rated stocks. The main reason is the fundamental change in the way companies generate value, which has not been adequately captured by financial accounting standards. While knowledge based industries have high levels of intangible assets, value investing tends to focus on historic tangible asset values. As technological change becomes more ubiquitous (we know that its impact tends to be underestimated in the long term) and increasing proportion of the value add comes from IP and human capital, the more of it is expensed and never appears on any balance sheet.

Failure of Static Analysis

In an economic sense the idea of mean reversion working in financial markets is related to the classical economic theory of perfect competition acting to compete away super-normal returns in a smoothly and evenly rotating economy, often helped by the (unrealistic) assumptions of perfect information and friction-less trade costs, not to mention the much maligned self interested rational economic actors. Equilibrium theories of economies, that so conveniently lend themselves to mathematical modelling and the deceptive cloak of hard science, are in fact nothing short of a dangerous form of deception, and models that fail to capture the much changed nature of how we create value in the era of digitally driven knowledge based industries. Brian Arthur described as long ago as 1996, this as the part of the economy yielding products that essentially are congealed knowledge with a little resources and operating under increasing returns. The world has changed structurally, and the discredited idea of a digital paradigm shift, or the snake oil salesman’s chant of this time it will be different, 20 years after they were first commonly heard in the investment mainstream, may yet win the test of time.

Creative Destruction Prevention

A cynic might say that value investing gets you a portfolio of cheap typewriter manufacturers. This harsh assessment does raise another interesting point about the forces that mitigate against the mean reversion of lowly valued shares. The forces of creative destruction (famously identified by Schumpeter) are a key component of the capitalist system. If you don’t make a return on your capital you will fail, and the assets are reallocated. The system is harsh, but effective. The factories that used to make typewriters are now largely redeployed into more productive purposes. However, over the past 30 years the institutional arrangements for allowing this capital reallocation to run efficiently seem to have broken down.

Fixed Interest Rates & Industrial Policy

From a macro perspective the impact of modern monetary policy in the form of QE and large scale Central Bank asset purchase schemes also largely mitigates against the operation of mean reversion. From a technical perspective these policies, distort the structure of interest rates and lower the time value of money and brings the future forward, placing a premium on those companies that generate most of their present value in future years, i.e. growth companies. While at the micro policy level specific government assistance to the private sector has increased significantly too. Often introduced after industry level consultation and discussion with self appointed lobby groups, specific industry level government support such as Cash for Clunkers, Help to Buy, and business rate relief, among dozens of others have all been growing. These measures have been pushed into hyper-drive in the post COVID policy repertoire which so far include direct government ownership of a failed satellite communications company, Eat Out to Help Out meal deals, measures to save the theatre, and a muted related lobby for assisting circus performers (so far resisted). These measures are meant to be temporary and expedient, but there is often nothing so permanent as a temporary government measure, and I would expect many to remain as permanent or semi-permanent features of our industrial policy.

Competition Policy Failure

Over the same period the inability of governments to regulate, or even tax multinational companies is combined with a significant slow down in the number of antitrust cases in the USA and effective competition regulation in Europe. This is at least in part due to the rapid increase in lobbying activity on behalf of the major multinational companies and their interest groups at government, EU and supranational levels. We can see major efforts to keep areas of economic activity alive post the COVID pandemic, even where it looks like a forlorn attempt to hold back the tides of economic reality.

We Are Turning Chinese

It is an irony that in the 20 years since the West accepted China into the WTO club of international trade, thus allowing China to utilise its vast labour force to such great effect, rather than result in the Chinese economy more closely resemble the Western idea of economic liberalism and fair trade, the reverse has happened. The key trading blocks of the USA and the EU are moving more closely to resemble interventionist planned economic model of China. Established companies have unsurprisingly adapted to this trend and worked out that competitive advantage can become entrenched and sustained via the capture of regulatory policy and direct government intervention. There are countless examples of this, but two examples include: GDPR adds another hurdle for anyone thinking of competing with Facebook or Google; EU air quality regulation favours diesel emissions over petrol emissions, while in the US it is the reverse, each policy adding protection to its respective incumbent auto majors. As John Kay described it, there are good grounds for fears that “industrial policy” means open season for lobbyists and Luddites, … the real achievements of the past 30 years in removing obstacles to productivity and innovation will be steadily eroded by the unplanned consequences of random interventions. This economic calcification prevents the efficient re-allocation of resources to incomers and innovators. The very destructive process that makes capitalism “the worst economic system, apart from all the others”.

Value Comeback

Having said all this, value investing can make a comeback, and mean reversion is capable to re-assert itself. However, it would, in my opinion, need a lot of things to change. A very sharp de-rating of growth stocks, maybe caused by a sharp spike in interest rates and an easing of QE and government stimulus; a significant change in government policy on competition law enforcement; a sharp reduction of industrial policy; and / or a prolonged period of high inflation. These are all potential factors to watch.But I believe that while value stocks might have short periods of out performance (as they have in the past), the long run secular trends of growth investing are likely to remain a more dependable and ultimately much more rewarding tailwind for investors to position themselves in front of.

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