Will Stock Picking Outperform Treasuries?
How concentrated portfolios can earn you below-average returns
Introduction
It’s time to do some reverse thinking. Why do we hold a concentrated portfolio of - in our opinion - quality growth companies with stable economics (that is: steady ROIIC, good reinvestment rate, return of excess cash to shareholders) and what could go wrong with this mindset?
Portfolio concentration is expected to produce poor absolute and risk-adjusted returns if you’re focused on traditional value stocks with poor quality. We argue that this kind of traditional value investing (based on low P/E, low price-to-book) doesn’t capture the positive tails needed for solid compounding.
Over the past two decades, we've transitioned into a globalized world. The power law distributions that traditionally defined regional industry structures and competitive landscapes have now expanded globally, creating a "winner takes all" market, especially as the world is constantly changing. In this context, a small percentage of the population generates the majority of the value, a concept illustrated by the Pareto Distribution, commonly known as the "80-20" rule, where 80% of the value is produced by 20% of the population.
Bessembinder study
To make this more tangible, the Bessembinder study is an extensive analysis of the returns of individual stocks in the U.S. stock market since 1926.
Conducted by Hendrik Bessembinder, a professor at Arizona State University, the study examines the lifespan, returns, and contributions to total market capitalization of stocks. The study concludes that the average stock investor is unlikely to outperform short-term investments such as U.S. Treasury bills. Only a small number of stocks perform exceptionally well and generate the majority of the returns in the stock market.
Bessembinder
One could argue that this is a result of the rise of the internet and the strong performance of technology stocks compared to the broader market. But even before the rise of the internet, global equity market returns were dominated by a select group of highly successful businesses. Most listed stocks tend to deliver unattractive long-term buy and hold returns. In his 2018 study of U.S. equity returns from 1926 to 2016, Hendrik Bessembinder found that a very small group of stocks was responsible for all equity market returns.
Specifically, the top-performing 1,092 U.S. companies (4.31% of the total listed stocks during this period) accounted for all the wealth creation from equity investments (i.e., returns exceeding those of treasury bills). Bessembinder's 2019 study expanded this analysis to 42 countries over the period from 1990 to 2018, revealing that global returns were even more concentrated. The best-performing 811 firms (1.33% of the total) accounted for all net global wealth creation.
The extraordinary returns from a small number of high-growth businesses result in the market's return distribution being positively skewed, rather than following a normal bell curve. These "winners" with high returns drive most stock market gains over the long term. For a long-term "buy and hold" investor to achieve excess returns, they must successfully identify and heavily weight future structural growth companies in their portfolio.
Alternatively, market participants, including fund managers, can attempt to outperform the market over short periods using active trading strategies. However, predicting short-term share price movements is exceedingly difficult. Portfolio managers employing short-term trading strategies operate in a highly competitive environment where share prices are random and unpredictable. This challenge intensifies as economic conditions shift from favorable to unfavorable, leading to declining intrinsic values for most listed stocks.
The study’s findings, often echoed in the press/media, suggest that since only 4% of stocks generate significant returns, active investors have little chance of achieving meaningful gains unless they hold one of those 4% stocks. Therefore, it is recommended to buy an ETF to ensure inclusion of these top-performing stocks, or to maintain a highly diversified portfolio with the same objective.
However, there are two nuances that we want to direct your attention to:
Today's mega caps, the likes of Apple and Microsoft, are so large that their emergence overshadows earlier stock markets. For example, Apple’s current market value is many times larger than the entire U.S. stock market 40 years ago. This does not mean there were no returns to be earned in the past; the absolute value was simply smaller than it is today. Small investors now have more opportunities than large investors.
It is also incorrect to assert that the remaining 96% of stocks produced no returns. This group includes moderately to well-performing smaller stocks, as well as all stocks, large and small, that experienced negative returns over their lifespans. The combined net return of these stocks is zero, but this 96% includes both winners and losers.
We’re particularly interested in another conclusion from the study, which looks at the percentage returns of stocks rather than their absolute value increases. Over their lifespans, about 30% of stocks outperform the market, which is significantly better than the 4%. However, if you construct a portfolio by randomly selecting stocks, as a buy-and-hold investor, you would still, on average, underperform the market.
Surprisingly, even during the period of robust economic growth from the mid-20th century to the Global Financial Crisis (GFC), most listed businesses were unable to deliver attractive long-term returns. Consequently, if an investor did not allocate sufficient capital to the small number of high-quality, structural growth companies that generated most of the long-term returns, it was challenging to outperform the risk-free rate.
Reverse thinking
To increase the chances of a positive long-term return, investors should focus on creating a limited investment universe by eliminating companies with dubious financials, products, management, or competitive advantages. This idea aligns with Charlie Munger’s "invert" principle, which suggests that solving complex problems starts by reversing your thinking process. Investors should focus on eliminating poor investments to create a better investment universe.
This means that when building our valuation model to assess potential IRR, a lack of conviction regarding the quantitative and qualitative aspects of a company must result in a no-go.
The Compounding Tortoise
Losing vs. winning game
This also relates to the analogy of a losing game versus a winning game. A losing game is one where the outcome is primarily determined by the loser’s actions rather than the winner’s.