News & Our Thinking

 Mean reversion. Per Investopedia, mean reversion is the theory suggesting that prices and returns eventually move back toward the mean or average. This mean or average can be the historical average of the price or return, or another relevant average such as growth in the economy or the average return of an industry.

We utilize the concept of mean reversion on a regular basis at Argent. In fact, it is a tool we employ when we evaluate our current holdings and ponder whether a stock or industry appears expensive relative to its past or to the market.  We also consider mean reversion when we look for out of favor stocks or industries.  An implicit concept of mean reversion is that a company or industry should be as valuable today as it was in the past.   In other words, the company or industry has not suffered a catastrophic event which precludes it from regaining its former value or worth.

I bring up the concept of mean reversion as it is particularly appropriate when speaking of a recent addition to our Large Cap Growth strategy, Celgene Corp. (CELG). CELG is a leading biotechnology company within the oncology space.  CELG developed a drug, Revlimid, for the treatment of multiple myeloma.  In addition to Revlimid, CELG possesses strong patent protection into the middle of the next decade and consensus sales estimates for CELG are for annual growth in the high teens.  Earnings, well, they are expected to grow even faster, making CELG a true growth stock.  Generally speaking, growth stocks usually trade at a premium to the market as investors expect their value to increase over time at a rate faster than the average stock.

In the case of CELG, the stock is currently trading at a relative price-to-earnings (P/E) ratio of 0.9x the market. Put simply, this is considered a discount to an average stock.  Furthermore, CELG’s five-year average relative P/E ratio is 1.25x the market, or a 25% premium.  This is where the concept of mean reversion kicks in.  If CELG is the same kind of growth stock today as it was over the past five years then it is fair to argue that CELG’s valuation should be 34% higher today than it is. To us, that is a pretty compelling argument.

We are well aware of the worry that drug pricing may come under pressure with the new administration and the attempts to repeal the Affordable Care Act. Additionally, there is concern that demand may fall if some of the current insurance protection is removed.  With these headwinds in place, we understand that CELG may not turn out to be the same company in the future as it was when it was trading at 34% higher.  However, on the other hand…it just may be.

In cases such as CELG, we are reminded that mean reversion is a powerful force that pushes stocks and industries back to fair value. While the execution of mean reversion can take a very long time and test investors’ patience along the way, it is a useful resource in the identification of favorable odds.  For Argent, mean reversion helps highlight stocks and industries that are getting a little rich and, for stocks like CELG, verifying where investors are likely underpaying for growth.

We have three successful equity strategies – Large Cap, Small Cap and Dividend Select. If you have questions on any of these, or know others who might have an interest in our mailings, please call us.