Spoiler Alert

By Patrick Donley, Matthew Gutierrez, and Shawn O'Malley, edited by Robert Leonard · January 04, 2023

*LinkedIn newsletter is posted at a one-day delay.

After spending more than a month reviewing dozens of submissions for our stock pitch competition, we're excited to announce the winners today! 🎉

Thank you to all who chose to compete, it was an absolute pleasure to read over the submissions. We have an incredible community of investors.

Here are the finalists 💪

1st place: David Bastian — ticker: AMRK

2nd place: Tyler Hicks — ticker: CNX

3rd place: Tristan Unger — ticker: LEGH

Honorable mention: Kyle Holmes — ticker: GNRC

Here's the market rundown:

MARKETS

*All prices as of market close at 4pm EST

Today, we'll discuss two items in the news: Why Meta is getting a big fine and what's causing natural gas prices to plummet, plus our main story on how mean reversion affects stock prices.

All this, and more, in just 5 minutes to read.

IN THE NEWS

💰 Meta Fined More Than $400 Million (WSJ) 

Explained: 

• A top European Union privacy regulator ruled that Meta (META) can't use its contracts with Facebook and Instagram users to justify sending them ads based on their online activity.
• The ruling, announced Wednesday by Ireland's Data Protection Commission, imposed fines of $411 million, saying the company violated EU privacy laws by suggesting such ads are necessary to execute contracts with users. 
• Litigation could take years. Meta, the parent of Instagram and Facebook, said it disagrees with the ruling and plans to appeal. The case will depend on how Meta receives legal permission from users to collect their data for personalized advertising. 

Why it matters: 

• Meta shares have fallen sharply from their September 2021 peak, down over 60% in the past year, and it has laid off thousands of employees. 
• If upheld, the ruling could mean that Meta must allow users to opt-out of ads based on how individuals interact with its own apps, which could hurt its core business. It's the latest headwind facing Meta, which is grappling with a major drop in ad revenue because of a change made by Apple in 2021 that gave iPhone users the choice of whether advertisers could track them.
• The ruling is one of the most significant judgments since the EU, one of Meta's largest markets, enacted a landmark data-privacy law to restrict Facebook and other companies from collecting information about users without their prior consent. The law took effect in 2018.  

☀️ Natural Gas Plummets Amid Warm Weather (WSJ) 

Explained: 

• Unseasonably warm temperatures across the Northern Hemisphere have melted down natural-gas pipes, mitigating dire forecasts of energy shortages and sinking Vladimir Putin's plan to squeeze Europe this winter.
• Natural gas futures ended Tuesday at $3.988 per million British thermal units, down 50% from summer highs and about where they were when Russia's invasion of Ukraine upended energy markets. 
• The plunge is not welcome news for drillers, whose shares were big winners in 2022. But cheaper gas is good news for households and manufacturers, and it could help further tame inflation in the coming months. 

Why it matters: 

• Mild weather is driving gas prices lower in Europe, a reprieve for a region that had feared rolling blackouts and factory shutdowns. Nat gas prices have nearly halved over the past month alone while the war in Ukraine rages on.
• European governments committed billions of dollars to shield consumers and companies from high energy prices after Moscow cut gas supplies to Europe last year. European officials described the move as Russia's attempt to undermine military and financial support for Ukraine. 
• Winter is far from over, but so far Russia's strategy isn't working. Warm winter weather is limiting demand, as is an EU effort to curb consumption. Some analysts, however, note that prices in Europe could rise again when the continent tries to refill stores for the 2023-24 winter without much Russian gas.

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WHAT ELSE WE'RE INTO

📺 WATCH: Why the dollar isn't going anywhere, explained by Peter Zeihan.

👂 LISTEN: How to pick stocks like Peter Lynch.

📖 READ: Oregon becomes first state to legalize "magic mushrooms".

THE MAIN STORY: MEAN REVERSION

Overview

What is mean reversion, and how does it impact an investor's returns?

Rebecca Hotsko, host of the Millennial Investing podcast, spoke with Tobias Carlisle on this topic in episode MI241.

Today, we welcomed Rebecca back as a guest writer to share her thoughts on the topic.

She writes the following. 

Breaking it down

Economic booms and busts, or the peaks and troughs of the stock market, are typical examples of 'mean reversion.' However, investors often overlook how mean reversion affects companies' valuations.

Famed value investor Jeremy Grantham argues that "profit margins are probably the most mean-reverting series in finance, and if profit margins don't mean revert, then something has gone badly wrong with capitalism. If high profits don't attract competition, there's something wrong with the system."

Buffett agrees, and in 1999, he stated, "you must be wildly optimistic to believe profits can remain high for any sustained period."

What causes mean reversion?

At an industry level, competition is the primary reason why mean reversion occurs, as fast-growing or highly-profitable industries attract new challengers. 

This competition eats away at companies' growth and profits. Eventually, the once fast-growing, profitable companies lose their competitive advantage or hit a mature point where most of their target market has been tapped. 

This is the typical business's life cycle, and it significantly impacts your returns as an investor. 

Mean reversion has two critical implications for investors:

• Highly-profitable companies growing faster than the average tend to slow down and become less profitable over time.
• Companies that were once profitable but now have declining profits, slowing growth, and are cheaply priced, may actually perform better over time. 

What to know

A simple mistake that investors make is overpaying for fast-growing profits at present by extrapolating that growth unrealistically into the future. 

If a company's earnings per share (EPS) is growing above the market average of about 13% for the S&P 500 on a five-year basis, then the company's shares should also be worth a premium to the market multiple.

Long-term returns, then, are derived from the company's earnings growth, share price multiple expansions or contractions (price paid for a dollar of earnings), dividends, and share buybacks. 

As investors, it's essential to make educated guesses on how these factors will drive our returns in the future.

An example

Let's consider a company that can grow its earnings per share at an exceptional 25% rate.

This impressive growth should warrant that the stock trades at a premium to the market. 

While a high-growth firm could outperform for years, most companies can't sustain such elevated returns before new competitors drive their margins down.

Consequently, you might think that a company growing so fast would warrant paying almost any price to own it. However, your return depends on not only the company's growth rate but also the multiple, or price, you paid for that growth. 

While it's impossible to predict where a future price multiple will be, history shows that it tends to be very mean reverting.

Let's further assume that the stock trades at a price-to-earnings ratio (PE) of 30, which is a premium to the average market earnings multiple of 20. 

If this company wields 20% growth rates for any meaningful period, it's less likely, not more likely, that it can continue doing so. 

Suppose the company grows at 25% for three years before slowing to 20% in years 3-6 and then plateauing at the market average of 13% in years 6-10. 

At the same time, because growth is slowing, the earnings multiple investors are willing to pay contracts from 30 to the market average of 20. 

This is the result: 

Over time, as growth slows and the price multiple for its share correspondingly contracts, this investment's compound annual growth rate (CAGR) over ten years is 10.65%, and you would have turned $10,000 into $27,514. 

This isn't bad by any means, but it's far from the 20-25% rate you might have expected from this high-growth company. 

Don't forget, though, that the higher the multiple you pay today, the bigger deal this is to your return later on. 

Let's compare our results with what an investor would get if the company could maintain the same multiple:

This result is drastically different from the first, where an investor expected this stock to earn an 18.59% CAGR over ten years with overly optimistic future price multiple expectations.

Closing thoughts

It's often more reasonable to assume a company's growth will revert to its industry's average, as opposed to the market average, and compare those results.

Hopefully, this helps frame how to reconcile forecasts for an investment's future earning growth with the anticipated earnings price multiple to develop better investment return expectations. 

And if you're stuck or want to know the historical growth rates by sector (compounded annually), along with the five-year growth rates in EPS, Aswath Damodaran publishes these data sets on his website.

As a spoiler alert, the famous investor and educator Aswath Damodaran will be on the Millennial Investing podcast in January, so don't miss his masterclass on valuing stocks. 

Make sure to follow the channel in your podcast feed to listen when it comes out. 

SEE YOU NEXT TIME!

That's it for today on We Study Markets! 

See you later!

All the best,

P.S The Investor's Podcast Network is excited to launch a subreddit devoted to our fans in discussing financial markets, stock picks, questions for our hosts, and much more! Join our subreddit r/TheInvestorsPodcast today!

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