Portfolio management is a mixture of art and science. For us at Smead Value Fund, the art comes from intangibles and intellectual property. The science comes from accounting, economics and statistics. We would like to discuss statistics with a view toward the pendulum-like nature of investment markets. Some call this tendency of markets, “reversion to the mean”. If the stock market index has averaged a price-to-earnings (PE) multiple of 15 over an extended time period, then statisticians believe it will revert to a 15 PE multiple after bouts of extreme pessimism or maniacal optimism. At the end of the first quarter of 2011, it appears to us that an above average number of asset classes, stock sectors and industry groups were trading as statistical outliers. To be a statistical outlier, in our opinion, the market or sector or industry in question must be in statistical territory in which it has spent less than 5% of the previous 30 years.

Seven Statistical Outliers

1. In the last 110 years, Treasury Bonds averaged an interest rate of 4.9%. The rate is even higher during the last 50 years. Investors poured billions into bond funds in 2009 and 2010 and the in-flows were at record levels. The current interest rate is around 3.3% on the Ten-Year Treasury Bond.

2. The US economy was the most successful “emerging market” economy in history. It grew 4.13% per year on a real basis from 1800 to 1900. It did this despite 15 recessions and four depressions and a massive Civil War which took the lives of one out of every twenty American males. These economic contractions served to clean the system of business fraud and over-leverage and promoted a healthy frugality in the US. China has embarked on elements of capitalism for 30 years and many believe will usurp the US as the largest economy in the world in the next twenty to forty years. We computed that the economy of China has grown from $189.4 billion to $4.9 trillion from 1980 to 2009. This was a nominal growth rate of 11.5%. Where are the recessions and depressions?

3. Bespoke Investment Research reported that Energy stocks rose more than 40% in the six month period ending Feb. 23, 2011. It was the sixth time it had happened in 70 years. Energy has dominated the S&P 500 Index from a performance standpoint since the market low in 2002. It is much like the strength in Oil stocks from 1973 to 1981.

4. The Dow Jones-AIG chart of inflation adjusted commodity prices shows that there has been a consistent downward bias to real commodity prices. There have been three counter-trend rallies in 70 years, including the one we are in.


Source: mjperry.blogspot.com

5. Housing starts are the lowest they’ve been since 1960 as the chart below shows. Adjusted for population size this statistic appears almost off the charts low. Housing affordability tells the same kind of statistical story on a fifty-year basis as well.


Source: U.S. Department of Commerce: Census Bureau

6. The folks at Hays Advisory provided us with a chart comparing the S&P 500 Index of large-cap stocks to Russell 2000 index of smaller cap stocks going back thirty years. The last eleven years of outperformance by small-caps creates the kind of PE spread similar to the over-pricing of large cap stocks in 1999. It laid the groundwork for the current long-term outperformance by small-caps.


Source: Hays Advisory

7. Big Pharmaceutical stocks, as represented by Johnson & Johnson, Abbott Labs, Merck, Pfizer, Eli Lilly and Bristol Myers have comprised a weighting between 3.25% and 8.75% of the S&P 500 Index from 1982 through the end of 2008. These “medicine makers” have lagged the market rally since January 1, 2009 and by our calculations make up the smallest percentage of the index they’ve been since 1982.

If reversion to the mean occurs in the next five years, here is what we believe will happen:

1) Bond Prices will decline in the US 2) China will have a recession or depression 3) Oil stocks will perform poorly 4) Commodity prices will decline sharply 5) Housing will come back in the US 6) Large Cap US stocks would outperform small caps 7) Large Cap outperformance would be led by Big Pharmaceutical and Healthcare Company shares

We at SCM believe these things will happen and have built our portfolios using our eight proprietary criteria to avoid outlier over-popularity while investing in high quality companies in statistical outlier sectors and industries which are subject to extreme pessimism. We look forward to the remainder of 2011 and the coming decade.

It appears that good stock selection, with an eye on low PE’s and long duration business characteristics could be very successful for the patient US equity fund manager. It also appears to be quite contrary to the popular view and methodology of active managers in 2010.