Did you know that most shares are terrible investments?
That’s not something you often hear from people in my industry.
But it’s the shocking statistical truth.
It’s often said that equities are the best asset class.
It’s often said that equity markets should earn 7%-8% per year, on average.
I believe both of those statements to be true.
But this does not mean that any particular share has a good chance of performing well.
In fact, it’s quite the opposite: any particular share has a very poor chance of performing well.
Hank Bessembinder is Professor in Business at Arizona State University, and he has been studying the returns from 64,000 shares (both US and non-US).
Specifically, he tested whether or not these shares could outperform short-term US Treasury Bills, i.e. the lowest-risk investments. His analysis has just been updated (August 2021).
With his colleagues, he has found that an incredible 55.2% of US shares could not beat the humble Treasury Bill.
It was even worse for non-US shares: 57.4% of these could not beat the T-Bill.
I’d invite you to dwell on that for a moment. Internalise it.
What it means is that for every 20 random shares you look at, on average 11 of them will be economically pointless. They won’t even beat a risk-free investment. Return-free risk, indeed.
What’s special about Bessembinder’s study is that it focuses on long-term returns, i.e. the returns achieved by buy-and-hold investors who stay with their investments for many years. The time period studied was from 1990 to 2020.
Of course, if an investor has short-term insights that can predict how a stock will perform over the course of an hour, a day, a month or even a year, they don’t need to worry about these “long-run” outcomes.
But remember that traders experience vastly higher dealing costs compared to buy-and-hold investors. They have to be right, or commissions, spreads and taxes will eat their capital.
Most of us need a long-term approach that minimises transaction costs and taxes. This requires a different attitude:
“Lethargy bordering on sloth remains the cornerstone of our investment style.” - Berkshire Hathaway letter to shareholders.
The peculiar shape of equity returns
It’s time to ask how both of these statements can be true:
Equities are the best (highest performing) asset class.
Most equities are the financial equivalent of dirt.
The answer has to do with something called skewness.
In simple English, positive skew means that stock market returns aren’t symmetrical: the number of “very good” stocks isn’t matched by an equivalent number of “very bad” stocks.
The truth is that markets are driven by a small number of exceptionally high-performing stocks.
Meanwhile, the vast majority of shares generate only a small portion of the market return, or indeed actively detract from that return.
In the words of Bessembinder and his colleagues:
Wealth creation is highly concentrated. The five firms (0.008% of the total) with the largest wealth creation during the January 1990 to December 2020 period (Apple, Microsoft, Amazon, Alphabet, and Tencent) accounted for 10.34% of global net wealth creation….
The best performing 1,526 firms (2.39% of total) accounted for all net global wealth creation.
Isn’t this startling?
Let me repeat: 2.4% of firms accounted for all of net global wealth creation. The rest of them need not have bothered turning up.
This is why I created Monopoly Investor: I want to find the top 2% of firms. Or even better: the top 1%, or top 0.5%.
And I wouldn’t bother, if I didn’t think it was possible to find them. I would park everything in an index fund, and leave it at that.
But look at the top five companies* in the study:
Apple
Microsoft
Amazon
Alphabet
Tencent (owner of Chinese social media services QQ and Wechat, and many other properties)
Do these five companies have anything in common?
Remember the traits that the legendary Peter Thiel says a company needs, in order to escape from the drag of competition:
Proprietary technology that is 10x better
Network effects
Economies of scale
Strong brand
A company only needs one of these to succeed. But if it has more than one, it can be an absolute monster.
When you look at the top companies mentioned above, through the prism of Thiel’s “anti-competitive” traits, it becomes easier to understand how they generated such enormous wealth for shareholders.
Fundamentally, they succeeded because the competition couldn’t put up a fight.
Of course, there is never a guarantee in business. Any of these five companies could fail in future.
But like a card-counter at a casino, I think that if we combine the statistical vision of Bessembinder, the insights into the nature of competition from Thiel, and the lethargy of Buffett, it will be possible to tilt the future odds in favour of the investor.
And if we get it right, and if we allocate capital rationally, we should be richly rewarded.
Key elements of the strategy are:
Focus primarily on a company’s competitive advantages.
Don’t give up just because a stock has risen a long way: it’s in the nature of the best businesses that their shares will rise for many, many years.
Don’t forget the financials and valuation. They do still matter. A bear market is long overdue, and we can expect valuations to be brutally compressed - particularly for inferior businesses.
Be patient.
Will you join me? Each month, I’m producing at least two detailed research notes on companies with monopolistic characteristics.
And to celebrate my presentation at the Mello Conference on Monday 6th September, you can join me for a free trial for the next month.
Here’s the link. The offer expires in ten days.
Good luck out there,
Best regards
Graham
(*Disclosure: I own Alphabet shares, and I indirectly own Apple shares through Berkshire Hathaway.)
Most shares are terrible investments
Excellent points..although I suspect you could improve on those returns simply by avoiding companies with negative free cashflow.