Over the past two years there’s been a lot of talk about the mean-reverting nature of margins as a crucial source of the market’s “overvaluation” today. John Hussman and Jeremy Grantham have been two vocal advocates of this point. Here is Hussman’s chart to that effect:
In this debate, Bulls have pointed out a relevant counterpoint: that mean reversion can be to the trend, which has been higher due to more capital lean businesses, greater productive efficiencies, and international diversification, rather than simply to the longer-term average (here’s a good post from Joe Wiesenthal which covers this point and more). This trend/mean distinction is important, for a reversion to trend would imply margins still move higher over time, albeit only after a move back to and most likely beneath the more recent trendline.
Mean Reversion in Markets
Mean reversion is a powerful force in markets. One of the reasons why it works so neatly in is that when certain spreads divert from their long-run means, there is an economic incentive in the form of arbitrage for position takers to drive the spread back down to its normal level. An anecdote would be helpful. The following is a chart of the spread between West Texas Intermediate (WTI) Crude Oil (ie the “American” oil supply) and London Brent Crude Oil (ie the rest of the world’s oil supply):
We can see that over the long run, this spread exists within a relatively narrow channel; however, something happens in 2011 that sends the price of London Brent shooting upward relative to WTI. We’ll forget about why and focus on how this spread ultimately reverted back to its normal confines (though it does seem to have perked up again). While there are logistical challenges in sending crude from North America to Europe and vice versa, when the price of oil gets too high in one place relative to another, arbitrageurs can make free money simply by buying oil where it’s cheap and selling it where it’s too high. This is the definition of riskless profit. As more and more arbitrageurs engage in this activity, what is a large spread gets whittled down until there is no more “free lunch” as they say. This is how efficient capitalist markets work.
Capitalism, Economic Profit and Competition
In the latest GMO Commentary, Ben Inker makes the following point about margins, market valuation and corporate investment: “The pleasant way we could be wrong is if the U.S. is about to embark on a golden age of corporate investment and economic growth that will gradually compete down the current return on capital such that overall pro?ts manage to grow decently as the P/E of the stock market wafts slowly down.” What I find ironic is that corporate investment is the most common way margins can and do come down in capitalism, therefore, the most likely way for GMO to be right requires that they are wrong. Let me explain.
In a capitalist system, economic profit is not supposed to exist. Economic profit is the difference between returns on investment and the cost of capital for a business. When economic profit does exist, it is supposed to be followed by a period of economic loss, such that over a cycle, there is no economic profit. This is where the idea that margins mean revert comes from. Here’s Wikipedia’s explanation for how economic profit results in competition and no winners (ie excess profiteers) over the long-run:
Economic profit does not occur in perfect competition in long run equilibrium; if it did, there would be an incentive for new firms to enter the industry, aided by a lack of barriers to entry until there was no longer any economic profit. As new firms enter the industry, they increase the supply of the product available in the market, and these new firms are forced to charge a lower price to entice consumers to buy the additional supply these new firms are supplying as the firms all compete for customers. Incumbent firms within the industry face losing their existing customers to the new firms entering the industry, and are therefore forced to lower their prices to match the lower prices set by the new firms. New firms will continue to enter the industry until the price of the product is lowered to the point that it is the same as the average cost of producing the product, and all of the economic profit disappears. When this happens, economic agents outside of the industry find no advantage to forming new firms that enter into the industry, the supply of the product stops increasing, and the price charged for the product stabilizes, settling into an equilibrium.
This is good explanation, but I have presented it in the form of an oversimplification. Some kinds of companies are able to generate economic profit for long periods of time. These are the so-called quality companies with a moat (aka a sustainable competitive advantage) that Warren Buffett looks for. Since such firms are the rare exception, not the rule, it’s worth studying them and learning about the traits they share. This is something I do on a regular basis, though for the purposes of this essay, it’s a digression. I bring up this point because considering how rare such firms are, it’s safe to apply the concept of zero economic profit to the economy at large, and in doing so, assuming that margins do in fact mean revert.
In essence, high profit margins revert to the mean much the same way as the spread between WTI and London Brent Crude Oil, though the subtle differences are important. Whereas the WTI/Brent spread is brought down with arbitrageurs, the economic profit of high margins is brought down with entrepreneurs. When entrepreneurs see high profit margins, they see an opportunity to undercut those margins, and in doing so, capturing some of the profits for themselves. However, entrepreneurs can’t buy something and sell it elsewhere to capture this profit opportunity. They are called entrepreneurs as distinct from arbitrageurs because they actually have to engage in the “process of identifying and starting a business venture, sourcing and organizing the required resources and taking both the risks and rewards associated with the venture” (the definition of entrepreneur from Wikipedia).
To paraphrase, in order to capture the excess economic profit born of a too high profit margin, entrepreneurs need to raise capital, they need to make tangible investments in building the infrastructure of a business, and they need to hire people on the ground to make the business work. Simply put, margins don’t just go down, they get competed down and eroded over time through factors and forces that actually improve the economy at large, with the benefit at the end of the day being lower prices and better supply available for end consumers. This reversion in margins is always a process, never a one-off event, and it surely happens faster in some areas than others (Clayton Christensen’s Innovator’s Dilemma is a great example