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One truism of the IT (information technology) sector is that the same companies never maintain leadership through two cycles of development. IBM led the first era when corporates first inducted IT. "Big Blue" lost its primacy during the PC era to Microsoft. In turn, Microsoft failed to dominate the transition to the Web. And now, Google, Twitter and Facebook are leaders in Web 2.0.
Cycles in high-tech industries are very quick and this could mean accelerated reversion to mediocrity. But how consistent is corporate performance anyhow? A study, conducted by Ambit Research in mid-2013, suggests that it is rare in any industry for the same companies to maintain dominance over an extended period.
Ambit looked at the BSE500. The study claims that only 15 per cent of sector leaders manage to maintain exceptional performance over a period of five years. Even in the case of the Nifty, (most of the 50 companies in the Nifty are also in the BSE500) about 50 per cent of outperformers revert to mediocrity over a decade. One in four sector leaders in the BSE 500 drops into the "laggard" category over a five-year period.
Note that the comparison of like to like by differentiation into sectors controls for cyclical changes, since cyclical factors affect all businesses in the same sectors. If an erstwhile sector-leader is overtaken, other companies within the sector are outperforming it. The study can't be called definitive since it lasts just nine years. But it is indicative and it used a large set of indicators. "Great" companies were denoted by above--median gross block increase, good sales to asset ratios, rising operating margins, improving debt:equity ratios, rising cash-flow generation, improved return on equity, etc. The set was divided into sectors and then into quartiles within sectors. Sector leaders were classified as firms in the top 25 percentile of the sector after averaging out these financial variables. "Laggards" were the firms in the bottom quartile.
The variables were calculated with a start date of FY 2003, and compared on rolling basis till FY 2012. The study discovered that 85 per cent of leaders slide back into mediocrity (second and third quartile) over a given five-year period. One in four leaders slides to the lowest quartile and becomes a laggard. It also seems Return on Equity (also called Return on Net Worth) and Return on Capital Employed (RoCE) were the two most sensitive indicators of changes in relative performance.
Importantly, over a similar five-year period, corporates in the lower percentiles are quite likely to move towards the top percentile. In this population of the BSE500, over the period 2002-03 to 2011-12, 18 per cent of corporates starting in the bottom quartile reached the top percentile. If that holds, roughly one out of five laggards becomes a leader in five years.
The study concluded with case studies of companies such as Airtel, Infosys, Tata Steel, Tata Motors, TTK Prestige, Titan, etc. These are all good examples of corporates that have gone from being undisputed sector leaders to struggling, and in some cases, also made recoveries. All this has some interesting implications. It seems the Indian market offers strong examples of mean-reversion. If the investor has a long time horizon, he should be looking to buy companies with mediocre financials and prospects of improvement, rather than market leaders.
This tendency to mean reversion also offers an explanation for why the famous "buy the dogs" strategy works. In this mechanical strategy, an investor filters out all the dividend payers in a broad index. Then he buys the five dividend-payers with the worst returns in the past year. A year later, after receiving dividends, he sells the best performer in the portfolio and replaces it with the worst performing dividend-payer. Over time, the return from this strategy seems to exceed passive index fund returns.
If mean-reversion is the cornerstone of a long-term strategy, the investor should be overweight on companies doing badly. In a portfolio of poor performers held for a five-year period, one in five companies may become a multi-bagger, and most of the others will offer positive returns as they improve and become mediocre. If analysis of the RoE and RoCE ratios helps to pick companies with the best chances of improvement, it may even be possible to improve the one in five ratio. This is contrary to most conventional strategies which advocate finding market leaders and buying them when valuations are reasonable. There could also be a longer optimum period when this contrarian strategy yields even higher chances of success.
