Classic Research: Mean Reversion in Corporate Profitability

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the February 1999 paper entitled “Forecasting Profitability and Earnings” (download count over 3,600) by Eugene Fama and Kenneth French. Is corporate profitability mean reverting due to competitive forces, as entrepreneurs exit relatively unprofitable industries and enter relatively profitable industries. Are there therefore predictable patterns in corporate earnings? Using a simple return-on-assets model applied to an average of 2304 firms per year over the period 1964-1995, the authors conclude that:

• Corporate profitability reverts to the mean at a rate of roughly 40% per year.
• Mean reversion is faster when profitability is further from its mean in either direction, indicating elevated competitive pressures.
• Mean reversion is faster when profitability is below its mean, perhaps motivated by prospects of bankruptcy or takeover.
• Mean reversion in profitability produces predictable variation in earnings. Changes in earnings tend to reverse from one year to the next. Large changes of either sign reverse faster than small changes. Negative changes in earnings reverse faster than positive changes.

In summary, corporate profitability and earnings growth exhibit non-linear mean reversion.

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