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Robertson: Only Time Will Tell

Written by David Robertson | Feb 7, 2020

A great way to learn more about any phenomenon is to gain perspective by examining it from different angles. While it is certainly true that a great deal is known about stock returns, it is also true that a broader understanding of the subject has been hampered by overly simplified narratives and recency bias.

What is needed is a fresh perspective and a fairly recent (2018) study provides just that. The study helps to better understand the proposition of investing in stocks and in doing so, provides valuable insights for long-term investors.

The study in question was conducted by Hendrik Bessembinder from the W.P. Carey School of Business at Arizona State University (h/t Steve Bregman from Horizon Kinetics by way of his interview with Real Vision). A key difference in Bessembinder’s approach is that rather than looking at returns from broadly diversified stock portfolios, he focuses his attention on “returns to individual common stocks.”

More specifically, he looks at the excess market value created from holding a stock over the value of simply holding a one-month Treasury bill. Drawing on data from the Center for Research in Securities Prices (CRSP) database, he analyzes the series of one month returns of each stock relative to a T-bill from 1926 to 2016. His finding is somewhat surprising at first look:

“More than half of CRSP common stocks deliver negative lifetime returns. The single most frequent outcome (when returns are rounded to the nearest 5%) observed for individual common stocks over their full lifetimes is a loss of 100%.”

He goes on to explain how this happens: “These results highlight the important role of positive skewness in the distribution of individual stock returns.” In other words, stocks have very asymmetric returns. Most stocks don’t create value relative to Treasuries (over their lifetimes), but a small subset of stocks create vast amounts of value. Bessembinder’s work highlights just how lopsided the contributions are:

“When stated in terms of lifetime dollar wealth creation, the best-performing 4% of listed companies explain the net gain for the entire US stock market since 1926, as other stocks collectively matched Treasury bills.”

Importantly, the poor performance record for most individual stocks casts a very different light on both active and passive management and therefore has important implications for investors.

For active investors, it highlights both a challenge and an opportunity. Since only a relatively few stocks drive all of the wealth creation, failure to have adequate exposure to those few will severely impair portfolio performance. This can be seen quite clearly in the comparison of median and mean buy-and-hold returns for the universe:

“The mean annual buy-and-hold return is 14.74%, while the median is 5.23%. The divergence is more notable for the decade horizon, where the mean buy-and-hold return is 106.8%, compared to a median of 16.1%.”

The key challenge of active management, then, is to establish sufficient exposure to the relatively few disproportionate value creating stocks. If a manager has no special capability to single out these types of stocks, active returns are more likely to be close to the median than the mean.

This reality also creates opportunities, however. Insofar as a manager does have research and analytical processes that create an edge in identifying value creating stocks, the chances of outperforming a passive index are pretty decent. Bessembinder notes, “Investors with long investment horizons who particularly value positive return skewness” can significantly increase their chances of outperforming. The reason is that such an effort can focus on the types of stocks that create disproportionate wealth and concentrate them in a portfolio.

Active management also creates other opportunities. Bessembinder’s study focuses on buy-and-hold returns which excludes the universe of stocks that create value for some period of time before losing that capacity. Active management allows managers to reap the benefits of value creation for part of a company’s life cycle and then to eliminate exposure if evidence of erosion arises. Further, when active managers focus on value creating stocks, there is far less need to offset the performance drag caused by the majority of stocks in the universe.

Of course, the implications for passive investing are just opposite side of the same coin. While passive funds are often lauded for their low costs, little attention is paid to their investment merits. Bessembinder reveals the investment proposition of broad index funds fairly clearly – and the main advantage is diversity. More specifically, owning a piece of everything ensures that you get exposure to the relatively few stocks that create excess wealth.

Along with that benefit, however, comes the baggage of exposure to a lot of stocks that do not create any value. Further, such funds also necessarily include exposure to stocks that are visibly overvalued with no inherent mechanism to hedge that exposure. Stocks that create value for some period of time but then lose out to competition and fade away are included on the way up – and on the way down.

This highlights another point, “Individual common stocks tend to have rather short lives” with a median of seven-and-a-half years. This means that long-term investors in broad market passive funds will churn through several generations of failed companies through the course of their investment horizons.

Based on these insights, we can characterize passive investing more by what it is NOT, than what it is. A broad market passive fund is NOT a collection of mostly value creating securities (over their lifetimes) nor is it an efficient way to gain exposure to businesses that do create long-term value.

Yet another useful lesson from Bessembinder’s study is that it lends historical perspective to individual stock returns by illustrating some important changes over time. For instance, “the percentage of stocks that generate lifetime returns less than those on Treasury bills is larger for stocks that entered the CRSP database in recent decades.” So, as skewed as the returns have been, they have become even more so over time. This progression is evidenced by the fact that “the median lifetime return is negative for stocks entering the database in every decade since 1977.”

Not surprisingly, the worsening trend in performance also coincides with “a sharp decline in survival rates for newly listed firms after 1980.” While a number of potential causes are at play,  prominent ones feature the increased prevalence of stocks “with high asset growth but low profitability”. History suggests this combination leads to lower survival rates.

This history is especially interesting because it contrasts so sharply with today’s market ethos. For example, many of the current market darlings such as Netflix and Tesla not only exhibit high growth and low profitability, but also embrace and promote those attributes. History suggests such companies are overfit for very specific business conditions that are unlikely to persist and therefore are unlikely to survive more challenging conditions.

The issue of resilience is one that Nassim Taleb captured well in his book, Antifragile. For example, he described how he only drinks wine, water, and coffee based on the logic that liquids that are at least a thousand years old have been adequately tested for fitness. While Taleb’s standards of fitness for beverages may be extreme, the point is still a valid one: With such a long history, these beverages have proven themselves safe over a wide variety of conditions.

The concept of resilience is also critical for long-term investors. Part of the reason is that companies that regularly operate at (or beyond) the thresholds of prudence are completely beholden to the graces of a favorable environment. Just as soon as things become even modestly more difficult for whatever reason, they do not have the wherewithal to survive.

This matters because for firms to be able to create a great deal of wealth, they must be able to generate excess returns, and also to do so repeatedly so returns can compound. That means survivability is also a precondition for significant wealth creation.

It really helps for long-term investors to keep this in mind. When stocks keep running up and the news is positive, it is easy to get caught up and lose perspective. Bessembinder’s study provides a striking reminder that the vast majority of these price moves do not reflect lasting value creation. In order to track lasting value creation, it takes company and industry research along with detailed analysis of economic returns and sustainable growth rates.

Finally, one of the great benefits of studying history is that it expands understanding well beyond our own personal experiences. Bessembinder’s study provides useful historical context but also much more. By uncovering the net returns of individual stocks over Treasuries, he also creates a much richer understanding from which to evaluate active and passive approaches to investing. Time will tell which approach is more useful for investors with long time horizons.


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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

2020/02/07
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