Your recent work focuses on the skewness of equity returns and that only a minority of stocks manage to beat short-term bonds. Could you highlight your most important research findings?
“The two key findings that surprised me, along with a number of others, are, first, that most stocks do not outperform Treasury Bills in the long run, and, second, that the net long-term creation of shareholder wealth in the stock markets is concentrated in very few stocks.”
Thousands of technology stocks have delivered disappointing returns in the long run as well, so the implication is not as simple as just ‘buy technology stocks.
Can you give us a sense of how the composition of wealth builders has changed over time?
“While I have not investigated this issue systematically, it is clear that a small group of technology-related stocks, such as Apple, Amazon, Alphabet and Facebook, are responsible for a substantial portion of the stock market’s recent wealth creation, particularly in recent years. In a new study, I provide an update on this.1 On the other hand, thousands of technology stocks have delivered disappointing returns in the long run as well, so the implication is not as simple as just ‘buy technology stocks’.”
Are there any common traits among companies that generate large amounts of wealth for investors?
“I recently released a set of four reports on this subject.2 Among other findings I document that top-performing firms most often have rapid organic, that is not based on acquisitions, asset growth, and in particular have strong cash accumulation. Top-performing firms are more also more profitable on average, despite higher R&D spending, and have profit growth rates that exceed their rapid asset growth.”
“Top performing firms in terms of accumulated rates of return tend to be younger and have more volatile returns as compared to more ordinary firms, while top performing firms in terms of dollar shareholder wealth creation tend to be older and do not have particularly volatile returns. Perhaps surprisingly, given that the distribution of long run market outcomes is highly positively skewed, which gives rise to the concentrated wealth creation outcome top performing firms do not tend to have highly skewed short run returns.”
Why do you think most stocks have a relatively short life in the public stock market?
“The economy is dynamic, perhaps to a greater extent than many realize. That said, stocks disappear from the public market – not just because of poor investment results associated with being on the receiving end of economies’ ‘creative destruction’, but also because companies are frequently acquired, which tends to be a positive event for investors in the acquired firm.”
How do you explain the finding that, over time, successively fewer IPO-ed companies, in percentage terms, have been able to generate positive lifetime returns?
“As you note, my main research results are attributable to the fact that there is substantial positive skewness in the distribution of long-horizon stock returns. I show, through simulations, that long-run skewness depends on short-run return volatility. Adam Farago and Erik Hjalmarsson3 show more rigorously that the main determinant of long-run return skewness is short-run return volatility. So, I believe the answer is that companies that have completed IPOs in recent decades tend to be riskier firms. Of course, that alone does not mean they were bad investments.”
You make an interesting observation that the degree of wealth concentration has actually increased over the last 25 years. What do you think is driving that?
“The short answer is that I do not know. But it may be the case that the internet-based economy has allowed for more ‘winner-take-all’ outcomes in certain industries.”
How do you see the skewness of returns evolving over the next five to ten years?
“I see no reason to think that the future will be markedly different from the past. Stated differently, I am confident that a relatively small proportion of stocks will be responsible for a large share of market performance over the next decade. Which stocks that will be is, of course, a much harder question to answer.”
There are more people who think or claim to be as talented as Warren Buffett, than there are people who are actually as talented as Warren Buffett.
What would your advice be for active investors, based on the findings?
“The implications for investors depend on the efficiency of the market and on the comparative advantage of identifying in advance which stocks will turn out to be long-run winners (or losers). Investors who do not have a comparative advantage along these lines, and who do not have a strong preference for skewness, should stick to low-cost, highly diversified, index funds. The reasons as to why have already been covered in all the textbooks. In addition, a poorly diversified portfolio has a less than 50% chance of beating a diversified portfolio.”
“If the market is not fully efficient – and I think this is the case – investors with the right comparative advantage should be working hard to identify the ‘next Amazon’. The big question is: who has the right comparative advantage? There are more people who think or claim to be as talented as Warren Buffett, than there are people who are actually as talented as Warren Buffett.”
This article is an excerpt of a longer interview published in our new ‘Big Book of Trends and Thematic investing’.