Superb businesses
The vital few
Every so often a new study about the stock market is published with head scratchable conclusions based on statistics.
I propose to discuss a recent study that has some useful insights relevant to the subject of investing in individual common stocks vs investing in equities via an index fund.
The study is titled: Long-term shareholder returns: Evidence from 64,000 global stocks March draft 2023 by Hendrik Bessembinder, Te-Feng Chen, Goeun Choi and John Wei.
Wealth creation
To understand the study, we need to learn what they mean by wealth creation. The authors define it as an excess return over risk free Treasuries. And it’s the return that is obtained over the long haul.
The notion of wealth creation is somewhat akin to the Equity Risk Premium, but it’s expressed as a dollar amount.
Over the last 30 years 1,526 companies globally (2.39% of the total of 64,000) generated wealth equivalent to total global stock market wealth creation. You may scratch your head.
The flip side of this wealth creation is lack of wealth creation resulting from investing in the remaining 97.6% of companies which collectively matched the returns of one-month U.S. Treasury bills.
One more pair of statistics
One other pair of statistics to note before we try to understand what is really going on. The study finds that 55.2% of U.S. stocks fall short of returns on one-month U.S. Treasury bills when using comparable investment horizons. On a more positive note, 44.8% of the 17,776 U.S. stocks in the sample created positive wealth, i.e., their long-term returns exceeded Treasury bills.
Putting this together
- The majority of publicly traded U.S. stocks that underperform Treasury bills are the 55.2% referred to just above.
- The universe of U.S. stocks, i.e., the 55.2% and the 44.8% collectively handily outperform the returns earned on Treasury bills in the long run.
- The wealth created by stock market investing is largely attributable to large positive outcomes to a relatively few stocks. Globally over the last 30 years the number has been 1,526 or 2.39% of all stocks.
How to explain this
There are several interacting explanations for these statistics. The first is that successful companies produce better returns than unsuccessful one. Second, all else equal, bigger companies (higher market cap) create more wealth than small companies. Third, companies that were publicly traded the entire 30 years created more wealth than those that were publicly traded for just a few of those years. There may also be some random factors at play.
Lessons for investors in common stocks
If you use a dart board to choose common stocks you will likely fail to create wealth. That is because, as the authors point out, the majority of publicly traded stocks underperform Treasury bills over the long term.
If you invest in an index that tracks all the stocks in the world you will enjoy wealth creation because, as the authors acknowledge, broad stock markets handily outperform the returns earned on Treasury instruments in the long run.
If you invest in an S&P 500 index fund, you will also handily outperform the returns on Treasury bills over the long haul.
Burning questions
The first burning question is whether investors had to identify those 1526 companies to participate in the wealth creation? And to be successful in future, will investors have to identify the 2% or 3% of companies that will generate future wealth. The answer is no. As pointed out above, an index that tracks all the stocks in the world will do that. As well, an S&P 500 index ETF will do that.
Investing in an S&P 500 index will generate a satisfactory return. The only problem is that the index also contains a lot of companies that are not creating wealth.
One big issue is as to whether investors have to identify the next Apple, Microsoft, Amazon and Tencent, in order to participate in wealth creation. The study shows that the top five firms (Apple, Microsoft, Alphabet, Amazon, and Tencent), which comprise 0.008% of the 63,785 firms in the sample, accounted for 10.34% of global net wealth creation. The remaining 90% of the wealth was created by the other 1,521 companies. So, no, you don’t have to identify the next Apple, Microsoft, etc.
I would hazard to say that in the U.S., over the next 30 years, there will be over 1000 companies that will create almost all of the wealth generated by publicly listed U.S. companies. Investing in these companies will generate superior returns. This can be achieved by investing in wealth generating businesses bought at very attractive prices and by pruning out of your portfolio companies that are not creating wealth.
Conclusion
The authors point out that the results of the study highlight the degree to which successful stock selection can enhance wealth. The average common stock will not create wealth. The vast majority of wealth creation comes from a reasonably sized cohort of successful companies. The trick is to identify them, stick with them (favorite holding period is forever) and prune out the weeds.
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Readers wishing to dig further into this topic might take a look at these earlier posts:
How to identify great companies to invest in – Part l
How to identify great companies to invest in – Part ll
How to identify great companies to invest in – Part lll
You might also look at my recent post:
How to distinguish a superb value creator from an also ran
And:
Do investors need to identify and invest in future FAAMGN stocks?
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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