1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #67!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In our podcast today we will review the findings from a research report from Dr. Hendrik Bessembinder published in July 2024 entitled “Which U.S. Stocks Generated the Highest Long-Term Returns?”
Enjoy!
2) WHY OWING INDIVIDUAL STOCKS IN A PPRTFOLIO HAS A HIGH PROBABILITY OF A NEGATIVE OUTCOME:
François Doyon La Rochelle:
We are back after a short summer break, I hope our listeners also enjoyed some time off. I will start this off. We believe our listeners will find Today’s topic very insightful. The mantra about stocks is that in the long run, you will make money despite the volatility in the short term. What gets lost in translation about this fundamental investing belief is that it only really applies to buying the market. Our regular Listeners know we preach broad market ETFs as optimal for most individual investors. So, it was interesting to see research that strongly supports this investing strategy. This summer an academic financial economist we follow, Dr. Hendrik Bessembinder - a professor at Arizona State University’s W.P. Carey School of Business - published a paper that makes the case that owning individual stocks in a portfolio has a high probability of a negative outcome. James, why don’t you report on Professor Bessembinder’s findings?
James Parkyn:
Thank you for that Introduction Francois. This latest study challenges our long-held belief about stocks. Most investors know that the stock market has delivered solid results over time. In his July 2024 paper, “Which U.S. Stocks Generated the Highest Long-Term Returns?” Bessembinder analyzed the returns of the 29,078 publicly listed common stocks contained in the CRSP database (or the Center for Research in Security Prices) based out of the University of Chicago, over the period 1926-2023.
His key findings are:
• On average companies appeared in the CRSP data for only 11.6 years.
• The median lifespan of a public company was just 6.8 years.
• Only 31 stocks were present in the database over the full 98-year period.
• The majority (51.6%) had negative cumulative returns—most stocks, in fact, destroyed value.
• The median outcome was a return of -7.41% per annum.
• The mean compound return outcome was strongly positive while the median outcome was negative resulting from the positive skewness in the distribution of compound stock returns. This is a lot of technical jargon, what he means is that the best-performing stocks create a positive compound return for the markets.
• Even restricting the data to include those stocks that had at least five years of history (but not more than 20) resulted in the majority producing negative returns.
• Even among the 30 stocks with the highest cumulative compound returns the results were relatively modest—the median annualized return across the 30 stocks was 13.03%, while the mean was 13.05% and the largest return was Altria Group’s at 16.29%. Altria is a name most investors may not recognize. This is the old Philip Morris stock the maker of Marlboro cigarettes. This finding is understandable, in my opinion, because compound returns are geometric, its return on return.
François Doyon La Rochelle:
These findings will come as a surprise to most investors. The fact that the majority (51.6%) of these stocks have negative cumulative returns is astounding to me. But given how well the broad US Equity market has performed over this period of almost 100 years, I believe we must assume that the negative or mediocre performance results of most stocks are overshadowed by the high returns from the very few big winners.
James Parkyn:
To support your argument, François, let me quote Bessembinder again: "Slightly more than 4% of the stocks that have been publicly listed in the U.S. since 1926 are responsible for all of the net wealth enhancement to shareholders. That is, long-run wealth enhancement in the public stock market is concentrated in relatively few stocks."
François Doyon La Rochelle:
What are some other surprises that come out of this study James?
James Parkyn:
Another surprise was that many stocks don't stay in the public markets all that long. As I said a little earlier, on average, stocks trade for an average of just 11.6 years, with the median or midpoint tenure even lower at 6.8 years. Of the 29,078 stocks analyzed, only 31 made it through all 98 years, from December 1925 on. So there is a big survivorship issue with publicly traded companies. Companies often get delisted from or kicked off stock exchanges owing to poor performance, or they get merged or acquired out of existence.
François Doyon La Rochelle:
Since only 4% of the stocks generate all of the wealth, what does Professor Bessembinder say about passive investing in all of this?
James Parkyn:
It’s a great question, François. Bessembinder’s latest study does not specifically discuss indexing. That said, his previous research gives a nod to this investing approach. In addition, in a recent podcast about this paper with Meb Faber, he confirmed that he invests passively for himself. This latest study builds on earlier research that also revealed that most of the market returns came from a small number of great-performing stocks. Bessembinder published a study in 2020, titled “Wealth Creation in the US Public Stock Markets 1926-2019”. In this study, he analyzed the long-run stock market outcomes in terms of the increases or decreases in shareholder wealth creation, relative to a T-bill benchmark. He introduced this concept of shareholder wealth creation that takes into consideration the full history of both net cash distributions and capital appreciation.
François Doyon La Rochelle:
What is the main takeaway from that 2020 study James?
James Parkyn:
To me François, it is that of the 86 top-performing stocks, which represent less than one-third of 1% of the total stocks in the study, collectively accounted for more than half the wealth creation. And the top 1,000 performing stocks, less than 4% of the total stocks, accounted for all the wealth creation—the other 96% of stocks just matched the return of riskless one-month Treasury bills!
He is saying that the big winners are not easy to spot, except in hindsight. I have a quote from him: "The only way to be certain of owning the stocks that turn out to be the future big gainers is to own all the stocks" in a broad index fund.
François Doyon La Rochelle:
Our regular Listeners know that we also believe "Stock picking is very difficult," even for professionals. I think it is fair to say that this latest research supports our belief that passive investing is the only reliable way for most individual investors to generate high returns. What else can you add James?
James Parkyn:
Our good friend Larry Swedroe, who we quote often in our podcast, reviewed this study recently. I quote from his article in Financial Advisor Magazine Online: “Since the historical record indicates that it is likely that the net wealth creation/destruction attributable to the overall stock market in the future will be concentrated in relatively few firms, and that active management is unlikely to benefit from that concentration, the winning strategy is to avoid active security selection and market timing.”
François Doyon La Rochelle:
I completely agree with what Larry is saying. On the one hand, yes the market currently is concentrated with the Magnificent Seven, but you cannot guess what the future high-performing stocks are going to be. Your best option is to remain broadly diversified so that you will own them all. Another way to say this is that buying the stock market has a positive expected return, but buying individual stocks does not.
In conclusion James, what can we say are the main takeaways for our Listeners?
James Parkyn:
Our Listeners should take away that it is highly unlikely they will have positive outcomes by investing in individual stocks. The Magnificent Seven stock's recent massive outperformance is tempting to follow but this exceptional outperformance is only evident with hindsight.
I will go back to Larry Swedroe to summarize: “Investors make mistakes when they take idiosyncratic, diversifiable, uncompensated risks. They do so because they are overconfident in their skills; they overestimate the worth of their information; they confuse the familiar with the safe; they have the illusion of being in control; they don’t understand how many individual stocks are needed to effectively reduce diversifiable risks; and they don’t understand the difference between compensated and uncompensated risks”.
François Doyon La Rochelle:
I would add to that James that by adopting the passive broad market ETF you are most likely to benefit from the modest differences in annual returns that lead to large differences in cumulative returns. Let the magic of compounding work for you.
3) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn: for sharing your expertise and your knowledge again today.
James Parkyn:
My pleasure. François.
François Doyon La Rochelle:
That’s it for episode #67 of Capital Topics!
Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com
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Again, thank you for tuning in and please join us for our next episode to be released on October 23rd . In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
See you soon.