Mean Reversion: The Third Time Is The Charm? by Alan Hartley, CFA of Black Cypress Capital
The rule of three is a principle with various meanings. For writers, it suggests that topics, characters, or events that come in a group of three are funnier or more effective than if a different number was used. For the superstitious, the rule of three can be either positive or negative: “third time lucky” or “misfortunes never come singly”. We intend to unashamedly draw on both meanings below.
The close of the second quarter marked three noteworthy milestones, the first of which has particular personal importance. On June 30, 2014, Black Cypress Capital turned five. So too, did the economic recovery in the United States. And while equity valuations have been making new milestones on a near daily basis, they are now priced to deliver total returns of just 3.0% for seven years.
Over the last five years, we outperformed broad market indices as well as the vast majority of other equity managers. But we are not alone in our success. There are other investors that have fared as well. The question of concern then, is how we–including our competitors–got here. The answer to that will determine the likelihood of future success.
Equity markets have risen with minor setback since early 2009. Today, we stand atop a mountain of gains that in hindsight make our climb seem easy. Remember that it wasn’t. We have had to navigate numerous exogenous risks (a possible Eurozone breakup, the “fiscal cliff”, debt ceilings fights), unprecedented government and central bank involvement, historically low interest rates that many feared were on the cusp of soaring and crushing the recovery, frequent recession “double dip” scares, inflation hysteria, all-time-high correlations between stocks, and over the latter part of this bull market, elevated valuations only becoming even more elevated.
The point is, as a manager of risk we have had a lot of opportunities to err. And though we have successfully navigated the investment landscape with higher returns and less volatility, the outcome of our diligence looks no different from the results of an investor that wasn’t paying attention or that threw caution to the wind.
Our strategy has been and will always be focused first on managing risk and second on generating outsized returns. By its very nature, such a strategy is at war with the hapless risk-taking of a late stage bull market. As a bull market ages, stocks become anchored to a future so bright that historical averages of valuation are claimed to no longer make sense or apply. And stock ideas of the highest caliber become harder and harder to find. Of course, this period can last for years and thus makes the business of managing risk all the more hazardous–in the short-term–for a prudent risk manager.
One of the tasks that we encourage you to do, dear reader (as both an investor in Black Cypress and quite possibly in other managers as well), is to determine how gains made over this cycle have been achieved. It is said that it’s only when the tide goes out that you learn who has been swimming naked. Well, it’s still high tide. And bull markets reward even the most foolish of investment strategies. We submit the following questions that could be asked today to help you determine as much before the tides goes out again. Were risks considered, properly weighed, and taken? Is a risk management process in place to protect against inevitable drawdown? Is the strategy robust across multiple types of market environments, including those with falling stock prices, or is the strategy a product of its time? The answer to these questions is critical.
Five years is considered by many to be the minimum period for which a manager’s track record of performance becomes statistically significant. While we don’t necessarily agree with this rigid five-year rule (shorter time frames can be equally meaningful if relevant circumstances were present), we are pleased to report five years of success. Particularly so because our results were achieved in an environment (stocks continuously rising from elevated valuations) which least favors our strategy. In his book Outliers, Malcolm Gladwell repeatedly claims 10,000 hours (approximately five work years) of “practice” is necessary before above-average performances can be achieved. In light of our already successful past accomplishments, that’s encouraging for Black Cypress’ next five years.
The U.S. economic recovery also turned five last month. While much progress has been made, more work needs to be done to eliminate significant economic slack. The U.S. has added only 500,000 additional workers since the end of 2007. Real wages have barely budged. Inflation-adjusted retail sales are just 3% above 2007 levels. Auto sales, while rising, have not fully recovered. And housing starts would have to rise more than 50% to match the fifty-year average.
Based on historically reliable metrics, the economic expansion should last for at least another year or two. The Fed will complete its quantitative easing program in a few months but will hold interest rates low for a considerable time, encouraging further growth in housing, autos, employment, and consumer spending. And even when the Fed does start to raise rates, the first several increases should have little, if any, negative economic impact.
While the economy has struggled to post meaningful gains since 2007, after-tax corporate profits are up more than 50%. The rise in profits is the driving force behind the broad-based equity advance. U.S. after-tax corporate profits eclipsed $1.7 trillion in 2013, a figure representing over 10% of the nation’s Gross National Product and the highest net profit margin in the country’s history.
High profit margins have important implications for valuation and future expected returns. Why? Jeremy Grantham put it best, “profit margins are probably the most mean-reverting series in finance”. Mean reversion, or regression toward the average, is the concept that if a data point is currently at an extreme level, it will tend to move closer to its average on future measurements. Historically, economy-wide net profit margins have averaged 6.0%.
In analyzing net profit margins, it helps to separate the figure into three parts: after-tax corporate profits is equal to (operating profits less net interest) times (1 minus tax rate). That is, $1.742 trillion = ($2.662 trillion – $0.489 trillion) * (1 – 19.8%). The benefit of this separation becomes obvious when the data is presented graphically.
Operating profit margins:
And corporate tax rates:
Over the last fifty years, operating profit margins have been subject to multi-year swings based on the profit cycle (which generally coincides with the business cycle), orbiting around an average 13.7% margin. During improving economic conditions, operating profit margins increase above this level. During recessions, margins decline below it. But note that there is no mean reversion for interest costs and tax rates. The former has fallen for 30 years while latter has declined for over 50 years.
Operating profit margins are the only part of the equation subject to competition- and business cycle-induced mean reversion. Interest costs and tax rates, on the