Rethinking Foundational Beliefs

The idea of using averages (average returns, growth etc.) as benchmarks on how investment decisions are made, and by extension, portfolios structured has been paramount. When we observe swings above and below historical norms (averages), it was usually assumed that it will eventually revert back to the average – also called mean reversion.

Mean reversion in and of itself doesn’t sound too critical, but the concept greatly empowered investors to stay the course when markets pulled back and also maintained perspective during periods of excess as well. This long-held principle still applies, however, in today's economy where structural forces are shaping more outcomes, mean reversion may no longer be a primary guide.

During a time when globalization flourished, demographics were favourable and fiscal/monetary policy was stable, averages made a lot of sense. Investments were mostly cyclical in nature and the important metrics like growth and profits orbited around long-term averages. Today, it is not that cut and dry.

So, what has changed?

Forces that impact the global economy today are actually not cyclical at all.  They are structural and continual.  This in turn has impacted how we rely on averages (more on this in my second blog).

Let's use demographics in Japan and India to help explain how relying on mean reversion may not be appropriate. Japan's working age population has declined by more than 15% since its peak in the mid-1990s. India on the other hand is estimated to add more than 100 million people to its labour force in the next decade¹. These polar opposite trends translate into very different growth paths, savings patterns and importantly, fiscal pressures. When looking at this example, there is no gravity pulling these two scenarios back to an average.

Technology is another example. Innovation today allows many competitive advantages to multiply rather than fade over time. Nortel and Cisco compared to today's top tech giants provides a clear case of this dynamic.  In the early 2000s Nortel and Cisco briefly dominated the global tech space, only to see their market share quickly plummet as competition ramped up. Today, the tech giants are enjoying a much longer period of sustained profitability. To quantify, the top 5 tech giants have held their profit margins above 30% for more than a decade, and their share of earnings relative to the index has continued to rise². Instead of following historical trends and reverting down, profitability has become longer lasting.

The global economic shift from cyclical to structural truly changes how we make decisions. The idea of a single average outcome, while it still exists, is less reliable in many uses. The future will have a much larger range of outcomes and possibilities than traditional models would imply. 

Another dynamic that has changed the way we rely on averages is the materially widening valuation gap in companies' future earnings growth. A closer look at U.S. equity markets helps tell this story. Companies in the top decile of expected earnings growth have recently traded at 30 times forward price-to-earnings multiples whereas the bottom decile companies traded below 10 times³. This gap is significantly wider when you look at historical averages and signifies the differences in structural positioning rather than cyclical growth patterns. This widening valuation gap is very important because it impacts one of the most important factors when investing – diversification.

This dispersion changes the way we look at risk when building portfolios. In a mean reverting, cyclical market, diversification across similar assets can help smooth returns and lower volatility. However, in a world where dispersion between the better and poorer performing stocks, owning "a bit of everything" can actually lessen the exposure to the few businesses that are well positioned to grow in a more structural global economy.

This consideration now poses a more challenging, but important, question: how can you tell if underperformance is just temporary or a signal of a larger structural shift? While a cerebral question, the answer is actually pretty logical. The answer requires a mental shift away from the hope of returning to prior returns and averages and determining whether the company (stock) is strategically positioned to benefit from economic forces that we are likely to see moving forward.