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The long-term stockpicking challenge

Most shares underperform cash over the long run
April 13, 2021

The name Hendrik Bessembinder might not mean much to many of you. But it should, because the work of this economist at Arizona State University lays down a challenge for every stockpicker who thinks of themself as a long-term investor.

He has found that most shares underperform cash over their lifetimes. He studied more than 61,000 stocks around the world between 1990 and 2018 and found that only 40.5 per cent of them outperformed US Treasury bills during the time they were listed. And yes, this does include reinvested dividends.

If this surprises you, it’s probably because our perceptions of the distribution of returns are distorted by two things. One is a survivorship bias. The minority of stocks that have thrived, such as Amazon (US:AMZN) and Apple (US:AAPL), loom larger in our minds than the stocks that have failed. But there are countless numbers of these, including ScotOil, Polly Peck, Woolworths, Northern Rock and so on and so on.

The other is that we don’t appreciate that the long term is very different from the short term. On any day or month as many shares outperform the market as underperform, But this doesn’t mean that in the long run half of shares beat the market simply because one period’s winners become the next period’s losers. It’s like the FA Cup. In each round, half of all teams win. But at the end of the season, only one team lifts the trophy.

You might wonder: if most shares do worse than cash, why have stock markets done so well?

Simple. It’s because a tiny fraction of stocks do fantastically well. Bessembinder estimates that just 1.3 per cent of shares account for all of the rise in global stock markets since 1990.

Which is a problem for stockpickers. Unless you have the skill or luck to find the one-in-76 shares that do really well – and the discipline to stick with them – you will underperform the market. Most active fund managers underperform over the long run. This isn’t (just) because they charge high fees and have little ability. It’s because the odds are stacked against them.

Herein lies the case for tracker funds. These guarantee you exposure to the tiny minority of stellar performers. And exposure to these increases as their price rises while exposure to the majority of losers declines.

If you don’t want a tracker fund, though, what can you do about Bessembinder’s findings?

You could question their relevance. That so many companies do badly is a sign of a healthy competitive economy in which profits get competed away. But the US has seen competition decline in recent years. John Haltiwanger at the University of Maryland points to a long-term decline in rates of job creation and job destruction as evidence of falling dynamism. And Jan De Loecker and Jan Eeckhout point to rising mark-ups as evidence of declining competition – findings corroborated by Thomas Philippon in The Great Reversal and by Brink Lindsey and Steven Teles in The Captured Economy. All this suggests that listed companies now face less competition and so are more likely to do well.

Sadly for investors – though not customers – this seems to be only true in the US. Bank of England economists show that in other countries monopoly power has not increased much. And in the UK – unlike in the US – there has been no trend decline in job creation and destruction suggesting no loss of competition.

We shouldn’t, therefore, rely on a decline in creative destruction to overturn Bessembinder’s results. There are, though, other things stockpickers might do to rise to his challenge.

One is to heed Warren Buffett’s advice and look for companies with “economic moats” – ways to fend off competition. But this might not be enough. It’s not just competition within an industry that can destroy companies. Take Nokia. In the early 2000s it had a dominant position in the mobile phone industry. It had the organisational capital and brand power that suggested strong moats. And investors priced it accordingly. But then the smartphone came along and Nokia’s products were no longer in demand. Its share price is now 95 per cent below its peak. Investors must watch out not just for competition, but for technical change. This is a problem for long-term stockpickers because the pace and direction of this is unpredictable.

A better option is to back not individual stocks but styles. We know that defensive and momentum stocks have beaten the market over the long run. Bessembinder’s findings don’t overturn this fact.

A third option is to have an exit strategy, one that gets you out before once-good stocks turn bad. One good candidate here is Meb Faber’s rule to sell when prices fall below their 10-month or 200-day average.

Both of these strategies, however, require regular monitoring of your portfolio so you ditch stocks when they lose momentum or defensiveness or drop below their moving average. To keep on the right side of creative destruction requires eternal vigilance – and even then there is no certainty you will do so.

If you are a long-term investor wanting a quiet life, you should choose tracker funds instead.