Blog - Investing Notes

January 12, 2006 - 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.

The following chart, constructed from historical earnings data and inflation rate data, plots year-over-year changes in aggregate operating earnings by quarter for S&P 500 companies from the first quarter of 1990 through the third quarter of 2005. The mean nominal (real) earnings growth rate over this period is 8.7% (5.8%). The chart shows that earnings growth is reverting toward the mean after reaching an historically high level during 2004. The current state of earnings growth, slightly above the mean for the "modern" economy, suggests that a modest deceleration of growth is more likely than acceleration. Note that the sample for these plots is small (low-confidence) in the context of the research done by Fama and French.

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

For related research, see Blog Synthesis: Valuation Based on Fundamentals.