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Strategies & Market Trends : The Rational Analyst -- Ignore unavailable to you. Want to Upgrade?

To: Freedom Fighter who wrote (1416)	9/14/1998 5:11:00 AM
From: HeyRainier	Read Replies (1) \| Respond to of 1720

[ Reversion to the Mean: Return on Equity ] To start off the week, I'd like to point out some findings that were mentioned in a recent issue of Smart Money magazine, in particular, the Streetsmart section. The article had to do with a study done on Return on Equity: based on the performance of 5,000 U.S. companies from 1963 to 1996, on rolling one-year periods for 10 years, the study showed that companies with exceptional ROE's (in one example, above 35%) tended to have their ROE's fall toward the average of all U.S. companies, while those with the lowest ROE's tended to move up toward the average. On the chart, one would see three lines: the high ROE companies gradually sloping down and to the right toward the mean at around 12% ROE. The middle line at 12% would stay flat, and the terrible issues with minus 15% ROE or worse, got out of negative territory within just one year, and gradually reverted back toward the mean. While exceptions to these results will always exist (monopolies like MSFT or super-dominant companies like KO), it does cause one to think a second time about investing in those issues that have performed rather extraordinarily in the market. These are typically the issues that have been recognized and have resultingly higher P/E's or Price-to-book values--in other words, issues that have been priced for perfect execution and with high expectations. It is no surprise then that these are the issues that have benefited from the sponsorship of the momentum crowd, the crowd that once drove such stocks as Jabil Circuit up to the stratosphere. But note also that these people are also the Gary Pilgrims of the world (the managers of the PBHG momentum growth funds, broken mutual funds that have severely underperformed the market as of late, and have been met with large redemptions), whose I-don't-care-about-value investment styles have historically been proven to be subject to loss and underperformance. Just read O'Shaughnessy's text What Works on Wall Street. Why so much disappointment for these highly touted issues? Competition. Remember that imitation is the sincerest form of battery, and when a company is making gobs of money, others will imitate it to drive down profit margins. As for the laggards, it's often not as bad as people think. Hence the profit opportunity. The flip side of the equation are those issues that have been badly bruised, written off, and truly under-estimated. These low ROE, P/E, and P/Book ratio type stocks may on occasion fall under Warren Buffett's cigar butt example, where you can still get a puff out of a cigar on the ground. It's not the best smoke out there, but you still get some worth out of it because you still managed to get a puff for nothing. Value and contrarian-type managers such as the old Warren Buffett, David Dreman, and others have benefited from picking from this abandoned crowd the issues with intact operations and still strong, yet overlooked fundamentals. So when thinking about picking up shares in that well-performing company, think again about the inferences that can be made from the study: for most companies, return on equity is a counterindicator to future earnings. Regards, Rainier