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B. Venkatesh

TECHNOLOGY companies have fallen out of favour in the stock market. Some attribute this to a phenomenon called mean reversion. What is mean reversion?

It refers to a phenomenon where the stock falls in value if it is above its long-run average, or rises in value if it is below its long-run average. How do you compute long-run average? You can use statistical models such as the autoregressive process to find the long-run average.

But why should stocks mean-revert? An understanding of the subject can be based on product cycles. Suppose company "Z" develops an out-of-the-box technology solution. As the company is a monopoly, it will generate pots of money selling the product. Naturally then, its stock will move above its long-run average.

Of course, other tech companies will want to join the race to make big money. So, they will replicate the product. As similar products enter the market, the product life cycle matures. This makes it difficult for company "Z" to sustain high margins. Investors will, therefore, price down company "Z" stock to, perhaps, its long-run average.

Now, consider a tech company "A" whose financial performance is poor. This company's stock price will be naturally priced below its long-run average. Suppose this company is acquired by another tech-company. If the acquisition is successful, company "A" will perform well. And that may push up its stock price towards its long-run average.

Investors applying quantitative modelling use mean reversion as one parameter. Two points are relevant in this context. Sometimes, the stock continues to trade above or below its long-run average for a considerable period of time. An investment based on mean-reversion may not, therefore, turn out right immediately. Besides, computing the long-run average is not all that easy.

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