I recently read The Black Swan by Nassim Nicholas Taleb. The book focuses on extreme and rare outlier events (both positive and negative) and the tendency to find simplistic explanations for these events.

One of the ideas I was particularly drawn to was the concept of Medocristan and Extremistan, fictional countries distinguished by non-scalability vs. scalability. In Medocristan nothing is scalable; everything is constrained by boundaries. For example, the salary of a doctor is constrained by hours worked, and the weight and height of individuals are constrained by biological factors. This results in a place which is thin-tailed where even the most extreme outcomes will not significantly affect the mean, and all outcomes can be explained by a bell graph or a normal distribution. In Extremistan, royalties from a song, book or an individual’s wealth, for example, are not constrained by boundaries. These distributions are scalable, will be much harder to analyse and will not fit into any standard models. The increased possibility of an event occurring outside the normal distribution is much greater and one of these events could change the properties of the distribution itself. These events are what Nassim Taleb refers to as “black swan events”.

The Link between Wealth Distribution and Stock Returns

Just like in Extremistan, wealth in society has significant concentration in the right tail, where the likes of Jeff Bezos and other members of the billionaire club sit. One might conclude that a causal relationship should be found between this and individual stock returns, simply because a large proportion of the world’s wealthiest 1% or even 0.1% probably made their money through ownership of companies which they helped to create or transformed in some way.

After doing some research, it turns out the distribution in stock returns is possibly even more concentrated than wealth in society. Professor Hendrik Bessembinder wrote a paper on this phenomenon in which he highlighted that the majority of stocks do not exceed the returns of short-dated treasury bills. When first read, this statement sounds absurd. It is common knowledge that over long periods of time the stock market has outperformed treasuries and most other asset classes. However, he highlights the skewness or concentration of returns in the best performing stocks is particularly large.

Professor Bessembinder’s paper looked at the total wealth creation from the US stock market from 1926 to 2015. He found that out of the 26,000 stocks that appeared in the CRSP database*, about 86 of the top performing stocks (less than 1% of the total amount) accounted for over half of the wealth creation. He also found that just 4% of stocks (the top 1000 names) accounted for all the wealth creation.

Large returns from a few stocks essentially offset the modest and negative returns from the majority. In some ways the results are unsurprising, with only very few companies in existence for the 90 years between 1926 to 2015, and the median stock only being listed for 7 years, insufficient time to build up significant compound returns.

* The Center for Research in Security Prices is a provider of historical stock market data

Does trimming your winners make sense?

The paper also found that more than half of stocks have negative lifetime returns; leading me to believe that trimming exceptional companies might not be the best idea.

Investment managers will often trim holdings they feel have run or they believe are trading at higher multiples than when they originally took the position. They will usually recycle these into stocks at lower valuations and stocks which are “out of favour” with other investors.

Knowing that only very few stocks return a meaningful amount, does this approach make any sense? The idea behind this is that a stock mean reverts around a fair value and by recycling into stocks the manager deems undervalued, this should improve the performance and possibly the risk management of the portfolio.

Whilst this sounds like criticism of investment managers, I am merely pointing out that for one investment manager to be selling what they deem to be an overvalued stock, another must be buying this “overvalued” stock believing it to be “undervalued”.

I am also not against active stock pickers. In fact, for passive indexes (investment strategy that tracks a market-weighted index) to perform well, it is essential that excellent index agnostic investment managers exist. It has been shown that high active share leads to a higher variance in outcomes for investors. This is usually skewed to the downside, but newer studies have shown investment managers who have high active share and low turnover tend to perform better over long periods of time.

Source: The search for outperformance: Evaluating ‘active share’ Vanguard Research

Another study by Cremers and Pareek found that among high active share portfolios, those which have substantially different holdings from their benchmark only outperformed if they had low turnover. Investment managers who had holding periods of over two years on average outperformed by over 2% per year.

It was also concluded that funds with high turnover generally underperformed. Among patient investment managers, those with low active share or “closet indexers” underperformed even with long holding periods. The reason behind this might be explained by not only lower trading costs but by benefiting from mispriced securities, which only normalise over a long period of time. In summary, markets provide opportunities for long-term active investors.

Does the statement from Bessembinder hold true in other markets and over shorter time frames?

Bessembinder’s study was over an excessively long period of time. Most investors are unlikely to have a 90-year time horizon, but by reducing this to a more modest period, would the findings still hold true? Reducing the time horizon will in turn reduce the variance seen in the underlying equities. It’s likely that many of the top performing equities of each decade might not be able to reinvent themselves to reach the age of 90, so a slightly different approach might be needed to capture decade winners in portfolios.

To examine this, we can look at total return and the contribution to returns of the FTSE 100.  While the results weren’t as extreme as Bessembinder’s, they were still very telling of how a few equities delivered most of the market performance.

Between 30th June 2010 and 30th June 2020, 175 equities had delivered a total return of 84% for the FTSE 100. The top 10 equities delivered over 50% of those returns, with the top 30 holdings delivering over 90% of those returns. Investors who didn’t hold the top 30 contributors and held only the other 145 equities did far worse than the market, receiving 7.81% or 0.76% annualised over the 10-year period. These stocks also underperformed Gilts* which delivered 15.75% or 1.47% annualised over 10-years.

Although the results weren’t as extreme as Bessembinder’s 90-year study, they do highlight that his original statement holds true. The majority of equities even over a 10-year period underperform Gilts. This leads me to believe that it is not only lower transaction costs which help low-turnover, high active share managers outperform but stock selection something which is backed up further by the facts around active share.  

*As a proxy for Gilt returns, I used the FTSE Actuaries UK Conventional Gilt up to 5 Years Index.

Given only a small number of equities heavily influence returns, how do we make sure we have exposure to these equities?

It is paramount as investment managers and allocators that we try and find the minority of companies which deliver all the returns: the positive black swans. I believe these companies exhibit certain characteristics which, if sort out through analysis, gives investment managers a greater chance of owning them, allowing them to deliver abnormal returns. This, when coupled with unconstrained index agnostic global investing, should increase the chances of outperformance. The four main characteristics I believe these companies exhibit is the potential to grow revenue and earnings multiple fold over the long term, scalable business models, economic moats and exceptional management teams. These stocks should also be purchased at entry prices which significantly undervalue the long-term opportunity for their businesses.  

Sources

Bessembinder, H., 2017. Do Stocks Outperform Treasury Bills?. SSRN Electronic Journal,.

Cremers, M. and Pareek, A., 2014. Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently. SSRN Electronic Journal,.

Taleb, N. and Chandler, D., 2007. The Black Swan. Prince Frederick, MD: Recorded Books.

‍Disclaimer: The views, thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.‍