Investors may use heuristics, or mental short cuts, to make valuation decisions rather than seeking to understand the true value of a business. One of the most common mental shortcuts is regression to the mean, or the idea that outcomes far from average will revert to average over time. The foundation for this understanding was established centuries ago with Adam Smith in The Wealth of Nations (1776) with the concept of the invisible hand. Alfred Marshall, an English economist, theorized if a good earns a high margin, competition will enter the market and offer it at a lower price, driving it lower to equilibrium. In valuing companies, the result is the assumption in the chart on the second page that companies earning a return on capital above the average may see their returns revert downward over time to the cost of their capital as those goods or services are sold in fewer amounts or at lower margins.
If this is true, how can our longest-term holding in the Sterling Capital Equity Income strategy have a higher ROE in 2024 than it did in 2007, and how could its return be continually above that of the market average over the same time period? Additionally, how can the market award it a higher P/E valuation multiple now versus then? Such examples challenge the regression to the mean belief as fait accompli (accomplished and presumably irreversible) rather than a statistical tendency. The good news is that investors employing regression to the mean as settled law may provide opportunity to other participants in the market that are willing to look into the deeper reality, searching for distinct investment models.
In our view, certain principles outlined centuries earlier are still valid for companies operating in a smokestack and bulk processing economy. In our search for advantaged-value companies, we have found companies that craft knowledge into their products and can generate increasing returns through market share gains and dominance, economies of scale, and international expansion.
We believe their advantage enables them to earn higher returns for longer than expected. Technology and pharmaceutical companies that develop and sell their products over time are prime examples of the types of companies we seek out. Why? The chart of the first page that shows that the market tends to award higher valuations for higher return companies. We took the top quintile (20%) of the highest ROE companies in the market and have shown the average P/E valuation investors are willing to award these high-quality companies. Across the board, the valuation premium is 20% or more to the market.
We would note how the market provides higher valuation multiples for greater sustainability of those returns and predictability of earnings. Finally, we would note that our Equity Income strategy earns the same median ROE as the top quartile of returns found in the chart, yet its holdings trade at a discount to the market. Perhaps therein lies the opportunity.
As always, thank you for your interest and trust managing your investments.
About the Author
Charles Wittmann, CFA®, Executive Director, joined SCM in 2014 and has investment experience since 1995. Chip is Co-Portfolio Manager of the Equity Income strategy. Prior to joining SCM, he worked for Thompson Siegel & Walmsley as a portfolio manager and (generalist) analyst. Prior to TS&W, he was a founding portfolio manager and analyst with Shockoe Capital, an equity long/short hedge fund. Chip received his B.A. in Economics from Davidson College and his M.B.A. from Duke University's Fuqua School of Business. He holds the Chartered Financial Analyst® designation and served as President of CFA Society Virginia from 2012-2013.
Related Insights
09.18.2024 • Brandon Carl, CFA®
U.S. Equity Market Performance Following the First Fed Funds Rate Cut
09.12.2024 • Will Smith, CFA®
Down but Not Out: Why Mid-Cap Value Appears Increasingly Attractive
09.04.2024 • Charles Wittmann, CFA®
08.27.2024 • Andrew DiZio, CFA®
Higher Interest Rates & REITs - Looking Ahead at Lower New Supply
Explore