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The Globe and Mail

Did value investors miss the boat on stock prices?

Fred Lum/Fred Lum/The Globe and Mail

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

The failure of two drivers of stock prices to work as expected has bedevilled value investors in recent years.

First is the failure of profit margins to "revert to the mean," and second is the rise in stock prices despite higher interest rates and expectations therein. Value investors' belief that profit margins would revert to the mean – that is, return to their long-term norm or average – and that higher interest rates were bad for stocks have prompted them to allocate a large percentage of their funds under management into cash and equivalents, which in turn has dragged down their portfolios' performance in recent years.

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Value investors believed that corporate profits and profit margins, which had benefited since 2008 because of declining commodity prices and a weak jobs market, were bound to revert to the mean.

Despite that, U.S. profit margins have been at or close to record highs for the last six years. According to data from the U.S. Bureau of Economic Analysis, the ratio of U.S. corporate profits after tax to GDP currently stands at 9 per cent versus an average of 6.5 per cent since 1950 and an all-time high of 10.26 per cent in April, 2012. The numbers are similar in key markets around the globe. Value investors have been stalwart supporters of mean reversion and the elevated profit margins have been a cause for concern for them. They believed that it seems unlikely that "this time is different" when it comes to mean reversion in margins. What goes up must come down. And the bewilderment continues.

But have there been structural changes over the years to make "this time is different" different this time with regards to the mean reversion of profit margins?

I see two possible structural changes.

First, in an effort to improve profit margins, companies have been buying their competitors – this way they increase their market share and control prices. Three or four huge players, for example, control the public "cloud" – companies that rent time on their servers to other companies as a service. EMC and Hewlett Packard Enterprise alone control 50 per cent of this market.

Second, single investors have started to control large stakes in firms that compete against each other. According to economic theory, such investors will want (and push) these firms to keep product prices high and wages low. This increases profits and profit margins, and lifts stock prices. A recent article in The New York Times indicates that in the 1950s institutional investors owned about 7 per cent of the U.S. stock market; it is now 70 per cent. According to the article, "institutional investors often own stakes in all the competitors in concentrated industries." The largest owners of Apple and Microsoft are Vanguard and BlackRock. A similar situation exists for General Electric, Whirlpool and Electrolux. A recent academic study found that airline ticket prices have increased by 10 per cent because of common ownership. Could this explain Warren Buffett's recent purchase of a large stake in four major U.S. airlines?

Moreover, value investors believed that the environment of artificially rock-bottom interest rates was going to end, leading them to the conclusion that there was an increased chance of higher interest rates going forward and lower stock prices. To be fair again, most investors shared the same belief.

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But can we have a rising stock market, even in a rising interest rate environment?

The usual argument goes like this. Investor expected returns are usually tied to the current level of interest rates. As interest rates rise, so does their expected return. This, in turn, pushes down the present value of future corporate profits or cash flows and the price investors are willing to pay for a stock.

However, this argument ignores the growth effect in the valuation model. Based on the equity valuation model taught at every university, the true rate that investors should discount future corporate profits is not just the expected rate of return, but rather the expected rate of return less the growth rate in profits.

As a result, a rise in interest rates may not necessarily be bad for stock markets, as long as economic growth conditions are such that interest-rate increases are lower than the increase in the rate of profit growth.

Value investors may have considered this, but wondered where growth in profits would come from in light of the many imbalances in the system.

Enter the new administration in the United States. Less regulation, lower taxes and more pro-growth policies are now changing the assumptions about growth, with growth expectations having been revised upward.

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Of course, value investors may turn out to be right in the end. If the new administration's policies lead to protectionism and trade wars, this will definitely hamper growth across the globe. And if curtailing immigration heats up the labour market, profit margins may be hurt. But the markets seem to assign a low probability of these happening.

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