The entire gain in the US stock market since 1926 was attributable to the best performing 3% of the listed companies.
Arizona State University professor Hendrik “Hank” Bessembinder wrote a paper titled “Do stocks outperform treasury bills?” in 2017 and made this discovery.
Hank’s paper was the first to provide an academic basis for the long-established investor practice of “running your winners”. That is to leverage the power of asymmetry in investing: The gains from successful investments can over time far outweigh the losses from failures.
Investment firm Baillie Gifford commissioned research in 2019 titled “Do Global Stocks Outperform US Treasury Bills?” and found that only 1.3% of stocks contributed all of the net gains compared to the performance of treasury bills.
Basically, a very, very small number of performers drive stock market returns.
Baillie Gifford arranged the research in a very nice spread over here but I would like to highlight some important points.
Over a long time frame, very few companies made a difference
A lot of wealth was created over the years in the U.S.
Hank measured wealth creation by using a formula to compare the return an investor will get by investing in a Treasury bill and by holding company stock. So that includes dividends, share repurchases, growth in market capitalization.
This set of data probably focuses on the US. It is kind of crazy that 83 companies create as much value over this long period as the other 25,584 companies.
This is why we say the role of diversification is not just to remove risks pertaining to a particular sector or company but to make sure we capture the returns from these top-performing companies that are so difficult to spot.
The 4 Fundamental Factors that drive Wealth Creation
Bessembinder finds that over the long run, returns follow fundamentals.
Great companies will be able to grow their assets organically and accumulate cash.
This is regardless of whether the company is young or mature.
The other two factors are a high allocation to research and development.
Lastly, there is also a strong correlation if the company have a larger drawdown in the prior decade.
This sounds awfully like value. It sort of means even if a company is great, the valuation we buy at is important as well.
Long-term investors in top-performing companies must stomach large peak-to-through share price declines
To earn great compounded returns means that we often have to live with uncertainties and volatilities.
Hank lifted three rather huge drawdowns for Apple. Has to be said that these drawdowns were less drastic in the past decade.
Here is Amazon’s.
What will really be abrasive to our fortitude to hold on is the magnitude of the drawdown but also the duration.
For the top 100 firms, the average drawdown in the decade they achieve success is 32.5% and the average duration is 10 months.
I learn the hard way that you want the money, you got to endure uncomfortable shit.
Top Wealth Creators Can be Non-Tech Companies
This is a strange one but I think it may be a spark off due to how well technology companies did in the last few years.
From his research, technology is not a prevalent driver of wealth creation.
There are more top performers versus average performers in non-tech domains. If we review the top performers, some of them tend to be in non-tech industries.
Baillie Gifford is rather interested in this research because the results do show that we should take a long term view, and focus on the fundamentals.
I think that is something they can identify with.
These reports provide substantial evidence that at times we would have to sit through quite a lot of pain if we wish to compound our wealth better than the MSCI World.
Some of you might come to another conclusion:
Missing out on the top performers can really dampen the result and picking the top performers might be a daunting endeavour.
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