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I posted this Newsletter some time ago. Since then we have a number of people joining our gang and so, given its relevance to what I’m about to discuss for Company B, I thought I’d repeat it.
A long time ago thoughtful investors discovered the tendency for companies which were once high-flyers moving into a more normal growth phases.
Conversely, shares which have poor recent records on earnings display a tendency to bounce back and grow at a rate much closer to the average.
Ben Graham chose the following to be the first words in his classic investment book (Security Analysis, 1934):
“Many shall be restored that now are fallen and many shall fall that are now in honour” (HORACE – Ars Poetica).
But what robust statistical evidence do we have for this mean reversion tendency?
Fuller, Huberts and Levinson, 1993
This is a great paper in the field, with a great title: “Returns to E/P Strategies, Higgledy-Piggledy Growth.…”. The authors use higgledy-piggledy to describe a state where earnings changes appear to be “randomly distributed over time”, i.e. future earnings changes are not related to past changes.
If this true then buying low price to earnings ratio shares should provide above-normal returns, because they have just as great a likelihood of an increase in earnings as the high PER shares but they sell at a low price.
To test for higgledy-piggledyness the researchers first identify the earnings yield of each company, i.e. the inverse of the PER in each year.
USA companies with a market capitalisation greater than $220m are included. This is approximately 1,000 companies per year from 1973-1990.
For each year, shares are put in order based on E/P ratio and assigned to quintiles, i.e. five groups each containing 20% of the shares.
Quintile 1 (Q1) contains shares with the highest E/P ratios for that year (value shares); the fifth quintile (Q5) contains the shares with the lowest E/P ratios (glamour shares).
As we now expect, consistent with other studies the value shares, Q1, gives higher one-year returns after portfolio formation. But that is not the main focus today. We are interested in the work they did on mean reversion in earnings per share.
Are earnings growth rates random or are they positively correlated?
The first thing they tested was whether the growth rate in eps over the four years prior to portfolio formation are correlated with the growth rate in eps over the four subsequent years.
They found that they were not. For the value shares the correlation coefficient was -0.086 and for the glamour shares -0.011. Let me translate for the non-statistical-nerds: These numbers are so close to zero – meaning no relationship – that they cannot be distinguished from zero.
Thus high growth in eps in the four prior years can lead to high, low or medium growth in the following four years. Similarly low eps growth over four years may or may not be followed by low growth afterwards.
The best test they conducted can be presented in graphical form – see below. First they worked out the average earnings per share growth rate………..
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