Thursday, April 27, 2017

Stock Returns Are Narrowly Represented Amongst A Small Group Of Names

An interesting point brought up by Eddy Elfenbein over at his blog "Crossing Wall Street" on the "Skewedness of Stock Returns".   Elfenbein in commenting on a recent paper "Do Stocks Outperform Treasury Bills," notes the following:

"When we say that the market returns, say, 10% per year, that’s superficially correct. But.....the large majority of stocks don’t do much of anything, and a tiny portion of homerun stocks make up for the entire gain. The numbers are pretty extraordinary.

{When looking at monthly periods the average stock gained 1.13% compared with the one-month T-bill rate of 0.38%.  But that average is very misleading since most stocks didn’t make money for that month, and even more lost to the T-bill. Although, when we weight its market size, the results get a little better.
After a decade, the “skew” is even more pronounced. The average stock gains 118% while the median stock gains just 14%. Only 37% of individual stocks out perform the market after a decade. Over the course of their lifetime, just 42% of stocks beat the one-month T-bill.
When we talk about total dollars made, just 0.33% of stocks make up for half of the wealth created by the stock market. Less than 4% accounts for the entire market’s gain. The other 96% combined match Treasury bills."
These results makes sense to me after 30 plus years investing in the markets.  When I started out and we built portfolios out of individual stocks, the rule of thumb was that in a diversified stock portfolio  on average over the course of a year about half the names would perform in line with the market.  Of those remaining, half had the potential to appreciate at some rate usually double that of the market and the other half had the potential to decline at some rate usually double that of the market.  Where you proved your worth, the theory went, was in your intuitive ability to cut your losers and let your winners run.  We know how good at that most managers are and were since most active managers routinely underperform the market.

I think the problem that active managers face today is that the data is suggestive that a small percentage of stocks outperform markets for any great period of time and there are likely not enough of these stocks to buttress a portfolio against the inevitable losses from names that disappoint.  Stocks that report bad news can lose 5-10% of their value or even more almost immediately as the news is posted.  There is usually little opportunity to avoid these in an era where all material news is mandated by law to be reported at the same time to everybody.

Markets tend to be very unforgiving to companies that disappoint.  Sometimes this can be seen in a stock as you will watch it trend lower over a period of time before the bad news comes out.  Too often though the news is random and out of the blue.  A drug in trials disappoints, a natural disaster takes out a company's facilities, bad weather, fickleness of consumers, unexpected competition and a whole host of other things can affect individual stock names unexpectedly and there is very little an active manager can do to counter their effects.

Just chalk it up to another reason why active managers are behind the eight ball in today's markets.