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Don't Invest Now Unless You Know Quality

Weather can be awful, with hurricanes, tornadoes, or other extreme storms. It can also be gorgeous, with a shining sun and a light breeze that cools you off if it's a touch too warm. But most of the time, the weather sits in between these extremes: Call it average weather. And if it gets to be too windy, rainy, or snowy, you can be certain it will return to average weather sooner or later.

This is the concept of reversion to the mean. And if you apply it to the current stock market, you might find that some of your investments aren't exactly poised for positive returns.

Jeremy "Mean Reversion" Grantham
A big proponent of this theory is Jeremy Grantham, predictor of the tech bubble, credit bubble, and China's recent slowdown. Through his investment management firm GMO, Grantham constructs predictions for the next seven years for a variety of asset classes based on current conditions. The latest numbers don't bode well for some widely held securities:

Asset Class 7-Year Return Forecast
U.S. Large Cap (1.2%)
U.S. Small Cap (2.7%)
U.S. High Quality 3.7%
International Large Cap 3%
International Small Cap 3.1%
Emerging Markets 7%

Table reconstructed from this GMO chart, courtesy of Institutional Imperative.

Both U.S. large- and small-cap stocks are predicted to have negative real returns over the next seven years. The only American asset class predicted to beat inflation is high-quality companies, which typically have large competitive advantages, high profit margins even in poor economic conditions, and diverse sources of revenue. Otherwise, investors will have to look abroad for positive returns, and would have to stomach the higher risk of emerging markets to enjoy a higher return. But even GMO is cautious of emerging markets, due to what they believe is a bubble in Chinese real estate.

But timing is an issue
Back in February, Grantham wrote that most things were "brutally overpriced." Since then, the S&P 500 has risen more than 10%. At an investment conference in May, James Montier of GMO said that the firm allocated 50% of its holding to cash. Since then, the S&P 500 is up more than 3%. While things may end up reverting to the mean in the long run, figuring out how long of a run is the crucial aspect to this investment theory.

Focusing on quality
However, even if you don't possess oracle-like timing or a firm grasp of emerging markets, the forecast for high-quality U.S. companies still beats inflation. When interest rates on the most generous savings or checking accounts barely return 1%, and the latest inflation rate was reported at 1.8%, high-quality companies seem like a great place for investments.

The largest holdings in GMO's own Quality Fund include Johnson & Johnson (NYSE: JNJ  ) , Oracle  (NYSE: ORCL  ) , and Google (NASDAQ: GOOGL  ) . All three have profit margins above 15%, worldwide operations, and strong respective moats. For Johnson & Johnson, its scale and name brands like Tylenol and Band-Aid lend it power over competitors. Oracle's advantage comes from the lock-in its customers experience, represented by its near-50% market share in database management. And Google's dominance knows no industry bounds. Its search engine holds a 66% market share in the U.S., while its Android mobile phone platform holds 64% market share of global smartphones.

Mean reversion
If large-cap and small-cap U.S. stocks revert to the mean and return less than inflation over the next several years, take solace in the fact that great companies can also revert to their own mean of market-beating returns. Even if you don't believe in any link between past performance and future performance, noting the high-quality characteristics of a strong competitive advantage, high profit margin, and diverse revenue sources -- all of which J&J, Oracle, and Google have -- can help you earn a greater return.

There are plenty of other high-quality stocks in the market other than those that GMO invests in. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names a few such stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Read/Post Comments (2) | Recommend This Article (3)

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  • Report this Comment On July 18, 2013, at 11:41 PM, ScottAtlanta wrote:

    Although, I have no idea about this particular model, its projections look pretty reminds me of the sort of model people use to predict disaster when the the market indices recently approached those associated with the market meltdown in '08/'09.

    Both "regression to the mean" and the, let's call it, "this is when disaster happens" model...are based on a closed system a static if there were no dynamic inputs. In terms of economy, there's growth/productivity/efficiency. Factors such as these will always put upward pressure over time (long term, decades and centuries). But there are periods where these dynamic factors are so great they lay waste to the minimal linear predictions based on the past -- even when they include estimates for dynamic factors b/c these are drawn from the linear past too.

    Some believe that we are "at the knee of the curve"...the exponential curve that actually describes all human information and growth. These curves look linear...for thousands of years (see Kurzweil, now lead engineer at Google). During these periods, linear models work pretty well (regression to the mean, etc.). But If we are on the "knee of the curve" --- where everything that can be digitized can double in capacity about every year and decrease substantially in cost at the same time -- (think not only chips and electronics but all matter once it's digitized and 3d printed) -- these models won't hold....they'll drastically underestimate the growth that's about to happen/happening.

    Yes, you'll always want quality and I believe, you'll want those companies that are at the edge of these technological/information revolutions (tech/biotech/engineering/materials/etc.) But that's not just me....I've gotten these ideas from others who have looked at where we're at and made these sorts of analyses.

    Sorry about the ramble....but you made me do it....when you mentioned a linear concept of regression to the mean.

  • Report this Comment On July 19, 2013, at 3:17 PM, XMFHelloNewman wrote:


    Thanks for the comment, and that's an interesting take. I'd love to see some hockey stick growth in our technical abilities, and I agree those best positioned to capture the value of any such growth are the Googles of the economy. Meanwhile, I can get behind the thought that the older, more static companies that want to perpetuate the status quo over innovation currently have inflated values.

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