The trend is your friend is a famous adage on Wall Street. Numerous are the speculators using technical analysis and other “momentum traders” who try to enrich themselves by surfing on an uptrend. And contrary to what one might expect, investors having a long-term horizon and basing their decisions on fundamental analysis also have a strong propensity to follow the trend …
Take the example of a company with above average earnings growth over the last three years. It is likely that the fundamentalist investor identifies such a company as being of high quality and invest in it. Thus, betting that the company will maintain its above average growth in years to come. In short, he relies on a continuation of the trend.
People investing in the stock market through mutual funds also have a beautiful friendship with the trend. They often buy funds with the best performance over the past two or three years and hope they continue to perform very well.
More often than not, these investments are disappointing. By an obscure phenomenon, the strong performance of the stock or the fund seems to fade in the years following our purchase decision. Without really knowing it, the investor faces a very powerful principle in the financial world and in life in general: the regression toward the mean principle.
It is very difficult for a company to maintain a high level of growth for several years. Professor Josef Lakonishok has studied the statistics of U.S. public companies from 1951 to 1998. He concluded that the past growth rate of profits is not a valid indicator to predict the future growth of these! For example, among the companies that experienced above average growth in profits between 1989 and 1992, only 9.5% (1 out of 10!) were able to maintain this outperformance from 1992 to 1995. A percentage entirely consistent with the laws of chance …
An investor who expects a continued high growth is thus betting on a low probability scenario (one chance in ten). He is in direct confrontation with the principle of regression toward the mean. Meanwhile, companies that experienced a below average performance over a period of three years tend to improve their results in the following three years.
Regression toward the mean is not a purely statistical phenomenon. There is also an economic rationale behind the principle. A company with great success will attract competition and face heavy competitive pressures that can reverse its rate of growth towards the average of its peers. Similarly, a firm with poor results will take steps to improve its profitability. It may dispose of unprofitable activities or outright replace its management team. It is easier for a company to move from being “mediocre” to “average” than to stay on top of the pack.
Contrarian and value investors have realized that the trend is not a friend you can count on. They much prefer to team up with the principle of regression toward the mean. According to Prof. Lakonishok, this explains the historical superiority of value investing over growth. Clearly, the trend is not your friend!
The study by Professor Lakonishok on the persistence of growth rates
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