Concerns about Covid-19 remind us once again that volatility and corrections are part of the investment cycle. Even so, some investors can understandably find such episodes challenging. The temptation can be to sell, and this may be right in the short term. As highlighted in last month’s column (‘Seeking superior returns’, 7 February 2020), the portfolios adhere to established investment principles, including that of remaining invested, while seeking to add value over time.
However, in doing so, the portfolios also recognise an inconvenient truth. Recent ground-breaking research has confirmed that most stock market gains over time have been accounted for by just a handful of stocks. This has real implications when it comes to portfolio construction – as illustrated by the composition of the investment trust portfolios.
Do stocks outperform Treasury Bills?
In 2017 Professor Hendrick Bessembinder and his team of researchers at Arizona State University released initial drafts of a paper entitled ‘Do stocks outperform Treasury Bills?’ The research caused a stir in some financial circles. It highlighted the inconvenient truth that, when looking at the performance of more than 26,000 US stocks from 1926, the stock market’s total gain was attributable to just the best performing 4 per cent of stocks – with just 90 companies contributing half of all the wealth created.
Furthermore, it pointed to the fact that just under 60 per cent of stocks returned less than one-month US Treasuries – the equivalent of cash – over their entire lifetime. The conclusion is that investors were destined to underperform significantly, despite running the risk gauntlet that comes with equities, unless this small number of stocks featured in portfolios in sufficient size.
But could this be a phenomenon confined to the US? Could other markets show that the equity advance over recent decades has been more broadly based? In July 2019, Bessembinder and his team published further research directly addressing this point. The study looked at the performance of 62,000 stocks globally between 1990 and 2018. More inconvenient truths surfaced.
Again, 60 per cent of stocks failed to beat one-month Treasuries. However, perhaps the more revealing fact was that, outside the US, less than 1 per cent of all equities accounted for all the market gains over that period – significantly less than the 4 per cent highlighted within the US. Five companies alone delivered around 8 per cent of shareholder wealth created by stock markets globally – Alphabet (Google) (US:GOOGL), Amazon (US:AMZN), Apple (US:AAPL), Exxon Mobil (US:XOM) and Microsoft (US:MSFT).
The implications are meaningful. The established rationale of equity investment is to access superior performance when compared with other asset classes over time while, in doing so, accepting a commensurate level of risk. However, if these returns are accounted for by a very small number of companies, while a disproportionate level of risk is represented by the remaining laggards, how should investors respond when constructing and managing portfolios?
Theory and practice
The immediate response by some will be to point to the advantages of passive investment. The logic will be that the best way to guarantee these stocks are owned is to buy the index in order to own all the stocks. Passive exchange traded funds (ETFs) will therefore be the first port of call for some. Yet given the costs (albeit small) and variable tracking errors involved, portfolios consisting entirely of such funds are destined to underperform – however marginally.
There are better options. Given there is nothing to suggest things will be different going forward, the challenge is to find and invest in those small number of extraordinary companies that will produce the bulk of future market returns – perhaps assisted by a greater emphasis on identifying the laggards. This requires disciplined portfolio management, and probably a fundamental change in approach for some, when considering investment options.
For one thing, the implications regarding risk will need to be addressed through appropriate diversification. While focused on the quest for these extraordinary, higher-growth and higher-risk companies, it will be necessary for portfolios to ensure they adequately diversify away from equities into other less correlated assets as an investment journey unfolds.
The two portfolios reported on in this column are two of nine real portfolios managed on the website www.johnbaronportfolios.co.uk – five of which (LISA, Spring, Summer, Autumn and Winter) reflect a risk-adjusted investment journey that increasingly diversifies to help protect past gains while generating a higher income. The Summer and Autumn portfolios are named Growth and Income for the benefit of this column.
In broad terms, around 30 per cent of the Growth portfolio and 50 per cent of the Income portfolio are invested in assets other than direct equities as the need for diversification increases. However, within the decreasing equity exposure, there remains a conscious effort in both portfolios to search for these extraordinary companies.
For example, the portfolios hold such investment trusts as Finsbury Growth & Income (FGT) and Scottish Mortgage Trust (SMT), which very much focus on this quest regardless of company size. Both trusts seek and invest in what they consider to be extraordinary companies offering high growth over the long term even when valuations encourage others to be more cautious.
But the quest demands further nuances. Looking forward, it requires greater emphasis on identifying the common traits and factors of their predecessors to see if lessons can be learned. One of the early observations is that most participated at some stage during the early stages of what became very large markets indeed. This tended to be allied to businessmen who were zealous pioneers and leaders in their field. These are factors and qualities of which our own FTSE 100 companies tend to be sadly bereft.
A consequence of such observations is that perhaps investors themselves need to change their approach when selecting and holding investments. Too often comfort is taken in numbers – they can provide assurance and certainty in an uncertain world. Valuations can suggest companies are under- or overvalued according to criteria that often fail to reflect potential and leadership. Such straitjackets are seldom helpful.
The investment industry already recognises that human judgement is important otherwise computers, stock screens and technology would be left to manage portfolios. But what it better needs to do is identify the coming big markets and recognise the potential of early participants – even if valuations initially suggest caution. The dream needs to be better embraced. Equities can ‘only’ lose their entire value – they can multiply in value many times. Identifying such companies early can be particularly rewarding.
Within their declining equity exposure, the Growth and Income portfolios consciously retain a preference for smaller high-growth companies within the UK even though valuations may exceed the norm or their universe. In simple terms, ‘growth’ and the extraordinary companies contained therein are worth their premium. Examples include BlackRock Throgmorton Trust (THRG), Montanaro UK Smaller Companies (MTU), Standard Life UK Smaller Companies (SLS) and Invesco Perpetual UK Smaller Companies (IPU).
In general, this quest for extraordinary companies will also increasingly be pursued within the private equity space given it contains an ever-growing number of high-growth companies that no longer need to raise money on the stock market as early in their journey as was previously the case – in part, because of the internet. It is no accident the stock market is gradually shrinking. Examples held by the portfolios include Standard Life Private Equity Trust (SLPE) and, to a lesser extent, Oryx International Growth (OIG).
And the portfolios continue with their quest overseas via holdings such as Edinburgh Worldwide (EWI), which is a particularly good example. EWI seeks capital growth from a global portfolio of initially immature entrepreneurial companies which are believed to offer long-term growth potential. The portfolio does not seek to track any comparative index and so higher volatility is inevitable. A further example in this vein is JPMorgan Japan Smaller Companies (JPS).
Increasingly, the search for these extraordinary companies will be pursued with little regard to geography. As globalisation continues apace, whatever the pessimists may suggest, certain themes proffer an extraordinary selection of opportunities. Chief among them are technology and biotechnology – two long-term portfolio favourites. Examples include Herald (HRI), Allianz Technology Trust (ATT) and International Biotechnology Trust (IBT).
But in their quest, what of the portfolios’ remit to produce an increasing level of income? This is helped by their increasing exposure to bonds, property and other assets. It is also helped by holdings that are now supplementing dividends from capital – examples being MTU, IPU, SLPE, JPS and IBT. In most cases payouts are linked to net asset value, which can make for a modicum of volatility but which are nevertheless welcome given the lack of income hitherto from most of these high-growth assets and themes.
The value of time
But there is another piece to the jigsaw. Difficult though it may be, picking the right companies alone will not be sufficient. Part and parcel of the change in approach needs to be the recognition that a truly long-term view needs to be adopted to realise the full potential. As Professor Bessembinder noted, it is the compounding of returns increasingly applied as time passes that produces the stellar results.
The symbiotic relationship between extraordinary companies and sufficient time needs to be better understood. Each time we use phrases such as ‘the time has come to take profits’ we need to question whether these are simply justifications for indecision or the need for predictability. Reducing exposure to these extraordinary companies too soon, during periods of volatility, would have denied investors the vast majority of gains that were to come. Significant goals usually require long-term horizons.
This should lead an investor not only to adopting active investment in seeking these companies, but also to hold them over the long term. This requires patience and at times nerve. This is why remaining invested over the long term, regardless of volatility, may not be sufficient in itself to achieve outperformance, but it is a prerequisite when seeking to realise the full potential of these extraordinary companies. And contrary to the pessimists, and those who talk purely of valuations, the world is throwing up many such opportunities.
Performance (Jan 2009 – Feb 2020)
Growth Income
Portfolio (%) 285.9 213.6
Benchmark (%) 159.3 125.3
Yield (%) 3.4 4.5
