Stock picking

Stock picking

Photo by Mario Crux on Unsplash

How often do we hear or read that a certain company, sector or particular type of firm will do well in the future?  Usually, this is backed up by some logical explanation of why and how these companies can be identified. 

However, when looking into the future it soon becomes apparent that a crystal ball would be useful and unfortunately, these are in short supply! 

At times of uncertainty, such as in recent months, it can be tempting to run ‘what if’ scenarios in our heads, such as ‘perhaps I should move into tech stocks and pharmaceutical companies, as surely these sectors will do well’ or to pick out specific companies that appear likely to thrive in the future. 

This though leads to two challenges.  The first is that you won’t be the first person to have this thought and these views in aggregate are already reflected in market prices.  The second is that in making such concentrated bets you have a high chance of being wrong and missing out on the companies that actually end up driving future returns.  Remember, 30 years ago Amazon didn’t exist.

To get a feel for what these concentration risks look like, academics are fortunate to be able to dig around in a vast bank of stock market data in the US, known as the CRSP database.  One such study from the Carey School of Business, Arizona State University[1] reveals some surprising and useful findings using data from 1926 to 2015.  Whilst investment wisdom and empirical evidence support the notion that stocks in aggregate outperform cash over longer periods of time, a forensic look at individual stock returns tells a very different story.  Here are some of the insights that the paper provides:

  • The median time that a stock is listed on the CRSP database was only seven years, during the period 1926 to 2015. That’s not long.
  • Just over 40% of all stocks have a holding period return that exceeds the return of cash (in this case one-month US Treasury bills) over the period that the stock was in the database. More than half deliver returns that are negative.  The median lifetime return on any single stock was -3.7% p.a.  That’s not good.
  • 26,000 stocks have appeared in the CRSP database since 1926, yet only 36 stocks survived the entire 90-year period. That’s not many.
  • US$32 trillion of wealth has been created since 1926 (to 2015), which has been generated entirely by the top 1,000 companies, representing less than 4% of the total number of companies listed over time. The top thirty firms (0.1% of all stocks) accounted for around 30% of the total stock market’s wealth creation. That’s pretty concentrated.


As the author states:

“Non-diversified portfolios are subject to the risk that they will fail to include the relatively few stocks that, ex-post, generate large cumulative returns.  Indeed the results help to understand why active strategies, which tend to be poorly diversified, most often lead to underperformance.”

So what is the conclusion you can take from this and other similar studies?  A simple and intuitive answer is that it makes enormous sense to remain highly diversified, as the risk of missing out on the next Exxon (the firm that has added most value to the US market ever), Apple or Amazon is too great. 

Looking at the changing top ten US firms by revenues in 2000, 2010 and 2020 is revealing in itself as by 2010 the top ten firms had five new entries.  Add 10 years, in 2020, and another seven different companies had replaced firms from 2010.  Over the 20 year period from 2000 to 2020 only three companies remained in the top ten US firms by revenues.

Trying to correctly pick which few companies are going to be driving stock market returns over the next decade or two will not be easy, or likely successful.  Making sure that you own them is more likely to be achieved by owning a broadly diversified portfolio with many hundreds, if not thousands of companies in it.  Missing out on the companies (that may not even exist yet) or sectors that drive future returns can make all the difference between a good outcome and a very poor one.

Cheers

Charles

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing. 

[1]              Bessembinder, H., (2017) Do Stocks Outperform Treasury Bills? WP Carey School of Business, Arizona State University.