Reversion to the Mean

In table 11, we reported the average returns on capital and equity for sectors in the United States. Within each of these sectors are some companies that generate above average returns and some that earn below average returns. There are at least three reasons for these differences:

1. Luck: Some of the differences across companies can be attributed to luck, and those differences are unlikely to be sustained. Thus, a movie company that generates a high return on capital because of a big "hit" will usually see its returns on capital fall back in the following periods.

2. Management Quality: A portion of the differences across firms can be attributed to the quality of management at individual companies, with well-managed companies delivering higher returns than badly managed companies. These differences can be sustained for as long as the company can hold on to superior managers; there is a market for managers that will lead some of them to be hired away by the competition for higher wages. Similarly, companies that earn below average returns because of poor management should be able to shed those managers over time and improve performance. In markets with strong corporate governance, this is likely to happen sooner than in markets with weak corporate governance.

3. Competitive Advantages: Some of the firm-specific differences can be traced to competitive advantages that some firms possess and these advantages can run the gamut from brand name (in consumer product companies) to lower cost structures (in manufacturing) to superior technology (in electronics). The period for which these advantages can last will depend upon the competitive pressures in the sector.

Over time, there is a tendency, albeit slow, for the returns at companies to converge on industry averages. We will return to examine this issue in more depth in the next section.

Excess Returns and Competitive Advantages

A firm that generates a return on capital (equity) that exceeds its cost of capital (equity) is earning a positive excess return. While this excess return may be justified using historical data or industry averages, the presence of these returns will undoubtedly draw in new competitors over time, putting downward pressure on these returns over time. In this section, we consider the potential competitive advantages that may allow a firm to generate excess returns and how sustainable they are. In the final section, we look at empirical evidence on how long firms have been able to maintain excess returns in different sectors.

Excess Returns and Economic Implications

The payoff to investing in new businesses and bearing risk is not profits per se, but profits that exceed what you would make on investments of equivalent risk. If we consider the cost of capital (or equity) to be the opportunity cost of investments of equivalent risk to the investments that a firm is considering, it is returns earned over and above these costs - excess returns- that create value in the first place. In competitive sectors, though, the presence of these excess returns will attract new entrants and imitation will push excess returns down. In a perfectly competitive market place, excess returns will not persist for more than an instant in time and all firms will earn zero excess returns. Herein, though, lies the contradiction of perfect competition. If firms can expect to earn no excess returns, there is little incentive to be in business in the first place. After all, why expend the time and resources of running a business to generate a return you would have earned by investing in a mutual fund with similar risk exposure?

For markets to be competitive, firms have to perceive an opportunity to generate excess returns for extended periods. For this to be more than perception, significant constraints have to exist on competitors entering and imitating the successful firm. These constraints can range from explicit restrictions, as in the case of legally sanctioned monopolies, to implicit constraints, such as the need for large amounts of capital or infrastructure investments.

 

See Technical Indicators