Most investors know that the worst possible outcome when you buy an individual stock is that it will go to zero and you will face a loss of 100 per cent. But we go ahead anyway because we know that the other side of that distribution is a potential gain of several hundred or even thousand per cent if we identify a winning stock.
Although a distribution of stock returns over the short term may approximate a normal or bell-shaped curve, for a long-term investor, the curve has a long tail out to the right with few but very large returns. In other words, it displays positive skewness.
An article in a recent edition of the Financial Analysts Journal (Spring 2023) suggests that positive skewness dominates market index returns and that it is extremely risky to venture away from the benchmark index weights of individual stocks unless you have some proprietary insights.
The four authors, Hendrik Bessembinder, Te-Feng Chen, Goeun Choi and K.C. John Wei, are on the finance faculties of universities in the United States and Hong Kong, and they cannot be faulted for skimping on the scope of their research. Their study covers 64,000 common stocks in 42 markets over the period from 1990 to 2020. In total, they looked at 8.37 million monthly price movements.
Worldwide, 27 per cent of the stocks (17,776) are located in the U.S., leaving 46,723 in other countries. Canada is represented with a sample of 2,001 stocks. All returns are converted to U.S. dollars for comparative purposes and the benchmark is the return on one-month U.S. Treasury bills.
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Their opening observation is an eye-opener: 55.2 per cent of U.S. stocks and 57.4 per cent of non-U.S. stocks underperform the one-month U.S. Treasury Bill Index over the full sample period. Canadian stocks do a little better, as only 53 per cent of them underperform.
This appears to contradict the widespread belief that stock returns typically outpace short-term fixed income over the long haul, so the authors are quick to address this issue. The positive premium for the market and the negative premium for most individual stocks is simply an illustration of the strong positive skewness in the distribution of returns to individual stocks over the long term. In other words, the positive returns observed for stock portfolios or market indexes are driven by very large returns to relatively few stocks.
Rather than computing the average return for individual stocks over different time periods, the authors instead compute the wealth creation for a buy-and-hold investor. This is defined as the increase in the end of period wealth to a shareholder as a result of investing in the stock rather than a one-month treasury bill.
Over the entire sample, 42 per cent of stocks had a positive wealth creation, leaving 58 per cent with a negative score. In dollar terms, the positive wealth creating stocks generated a total of US$98-trillion in gross wealth, offset by US$22-trillion in wealth reduction, for a net wealth creation of US$76-trillion.
After the article’s opening discussion about the impact of positive skewness, it’s no surprise to learn that the net wealth creation activity was confined to very few stocks. In fact, 1,526 companies (2.4 per cent of the entire sample) created US$75.7-trillion in net wealth – in effect, the wealth creation of the entire sample. The remaining 97.6 per cent, as a group, matched the one-month T-bill return.
Drilling down to specific names, the top five wealth creators were (in order): Apple AAPL-Q, Microsoft MSFT-Q, Amazon AMZN-Q, Alphabet GOOGL-Q and Tencent TCEHY. Given the size of the American market and perhaps the conversion to U.S. dollars, 35 of the top 50 stocks were U.S. in origin.
In many countries, a single top-performing wealth creator explains more than 20 per cent of that country’s gross wealth creation. For example: Anheuser-Busch InBev BUD-N in Belgium, Samsung in South Korea and Nestlé NSRGY in Switzerland.
No details are available for the top wealth creators in Canada, but our market appears to be just as concentrated. The top 5 per cent of stocks here generated 83 per cent of the net wealth over the sample time frame, not very different from the 88 per cent generated by the top 5 per cent in the U.S. and the global sample as a whole.
In the wealth destruction camp, the bottom 20 stocks include six Japanese banks, NatWest Group in Britain, plus WorldCom, Lucent and Wachovia in the U.S. Fortunately, no Canadian stocks made that list.
After all the statistical analysis, what message should an individual investor extract from this study? Perhaps the best answer is to quote the authors themselves:
“The wealth created by stock markets is largely attributable to large positive outcomes to relatively few stocks. Investors without a comparative advantage in identifying these few stocks are better off in a broad-based index fund.”
By chance, I have come to a similar conclusion myself. A significant part of my equity portfolio is invested in index funds and ETFs with broad exposures to sectors that I believe are currently out of favour – international banks and energy at present.
The remainder I invest in small-cap value stocks, more out of intellectual curiosity than an expectation of beating the market. I will, however, now be more inclined to hold onto the winners a little longer in the hopes of benefitting from that extreme positive skewness!
Finally, the study raises questions about the wisdom of paying a significant management fee for an actively-managed equity portfolio – unless, of course, you or your manager have that comparative advantage referenced by the authors.
It is no coincidence that money management firms are rolling out more passive or algorithm-driven products, and shrinking the size of their in-house research staff. This is becoming a low-margin business as clients have come to the same conclusion as the 64,000 data point research study and are gravitating toward passive investment products.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
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Robert Tattersall