A new study from Arizona State University, titled Do Stocks Outperform Treasury Bills?, is turning heads and gives ammunition to those who oppose active management to further bash stock pickers.
The study, by ASU professor Hendrik Bessembinder, found that over the long run individual stocks have done poorly even though the stock market as a whole has prospered. The researcher found that the typical stock has not even outperformed one-month U.S. Treasury bills, in the long run. The study shows that the stock market has performed well primarily due to the strong performance of a limited number of stocks that have done very well. In fact, only 4 per cent of stocks accounted for most long-run stock market performance, according to the study. Based on these findings, the researcher concludes that a low-cost index mutual fund is less risky and can produce better risk-adjusted returns in the long run than actively managed portfolios.
In my opinion, the authors of such papers and others who reach similar conclusions about active management lack a thorough understanding of what active managers do. In fact, such findings are not inconsistent with what value investors have talked about and what I teach in my value investing course at Ivey. Let me explain.
There are two kinds of value investors: Those who invest opportunistically and buy and sell based on the stock price vs intrinsic value, and those who invest for the long run and buy and hold. The former investors follow Ben Graham to the letter and look for severely underpriced neglected stocks, while the latter group of investors have evolved over time to invest in high-quality stocks with sustainable competitive advantage, an approach Warren Buffett follows.
In a similar fashion, broadly speaking, there are two kinds of companies in the markets: Companies that operate in a free entry market (that is, minimal or no barriers to entry) and those that operate within barriers to entry and enjoy a high degree of sustainable competitive advantage.
In a free entry market, companies tend to earn a return on capital that is close to their cost of raising funds. Many of these companies have a hard time even making a return close to their cost of capital. Close to 90 per cent of companies operate in a free entry market. It is very hard to create value in the long run in a free entry market. The most efficient companies do, but the rest do not.
Companies, however, that enjoy barriers to entry and have sustainable competitive advantage do create value in the long run. A buy-and-hold strategy would work here. This is exactly what good quality investing is all about, and this is how Mr. Buffett has been investing in recent decades. That is why the preferred holding period for Mr. Buffett is infinity. But Mr. Buffett was not like this in his early years. He was more opportunistic. Even though in the long run the free entry companies may flatline in terms of value creation, in the short run, an opportunistic investor can make a lot of money. And Mr. Buffett did. He made most of his money in his early years, when he was opportunistically targeting the 90 per cent of the companies that operate in a free entry market. One can now start to understand why the researchers at Arizona State University found what they found.
If 90 per cent of companies do not create value in the long run, most individual stocks would not return much over long periods, consistent with the study's findings. Most of the uptrend in the stock market would be because of the 10 per cent of companies that in the long run create value.
The performance of two Canadian companies can help illustrate the argument.
One company is Dorel Industries Inc., a diversified manufacturer of car seats, children's furniture and bicycles, a company operating in a free entry market, and the other is Stella-Jones Inc., a company in the railway-ties and telephone-pole business that enjoys a large degree of competitive advantage. Dorel has had a return on capital that has been at or below its cost capital over the years, whereas Stella-Jones has achieved a return on capital well in excess of its cost of capital.
What has the performance of these stocks been in the short run versus long run? In July, 2007, Dorel traded at $35; nowadays the stock also trades at about $35. Based on the ASU paper, this stock has underperformed Treasury bills and an active manager focused on the long run who had picked this stock would have failed his clients. But a long-term active manager who invests based on quality would have never picked this stock. An opportunistic value investor would – and would have traded the stock frequently. And he would have done well as the stock has fluctuated between $19 and $44 over the period, oscillating around $32.
A long-term investor following the Buffett quality approach would have bought and held Stella-Jones. Over the same period, Stella-Jones has risen from $11 in July, 2007, to around $44 today, with the stock having fluctuated between $4 and $52, mostly on an upward trend.
The ASU authors argue that active management cannot work, or it can work by luck. I beg to differ. As can be seen from the above example, an active manager could have made money in both stocks, but one in the short run and the other in the long run.
So let's not confuse things and, more important, do not confuse investors who struggle to find out how and with whom to invest.