Long-term stock market winners and losers

The Winners

Stock market investors in developed countries have long been winners. They have enjoyed higher returns in exchange for higher volatility than any other asset class. These excess returns have allowed them to retire earlier, more comfortably and pass greater wealth onto their children. In their long-term study of asset returns, Dimson, Marsh, and  Staunton found that equities significantly outperformed. For example, the following chart from their analysis in the Credit Suisse 2022 Global Annual Returns Yearbook shows annualised real returns for the U.K. markets:

Over an extended period, equities are the clear winner.

The Losers

That stocks outperform T-Bills has long been market orthodoxy. So it was a surprise when a recent paper looking at the returns of almost 64,000 global stocks appeared to challenge that universally accepted truth. The paper by Hendrik Bessembinder, Te-Feng Chen, Goeun Choi and K.C. John Wei looked at the long-run shareholder outcomes during a 30-year period starting in January 1990. Here is the surprising bit:

… the majority, 55.2% of U.S. stocks and 57.4% of non-U.S. stocks, underperform one-month U.S. Treasury bills in terms of compound returns over the full sample. Focusing on aggregate shareholder outcomes, we find that the top-performing 2.4% of firms account for all of the $US 75.7 trillion in net global stock market wealth creation from 1990 to December 2020.

And this isn’t just a U.S. phenomenon where recent S&P500 returns have mainly been driven by large cap tech stocks. Instead, the situation is even more extreme for the rest of the world:

Outside the U.S., 1.41% of firms account for the $US 30.7 trillion in net wealth creation.

However, Bessembinder et al. say their finding doesn’t, in fact, contradict the evidence of Dimson e al.  They also found that the mean buy-and-hold return across stocks greatly exceeds the U.S. Treasury bill return at each horizon. They explain that the difference between the positive return premium for the broad stock markets and the negative premium for most individual stock returns is due to something called “skewness” in the distribution. Skewness means that data points are not distributed symmetrically to the left and right sides of the median on a bell curve.

There is a strong positive skewness in the distribution of returns to individual stocks, particularly at longer horizons. This is visible in the graphs Bessembinder et al. include in their paper. For example, when looking at the percentage returns, almost no stocks generate a +50% or -50% return on the month:

However, as the period is extended, a greater number of stocks exhibit an extreme outcome. Here is the same graph for the yearly returns:

Here, more stocks are seeing extreme returns, including losing almost all their value. But, more importantly, the effect of positive skew is becoming apparent, with around 0.5% of all stocks doing better than 4x in a year.

Finally, here is the same effect over the entire 30-year study period:

Over the long run, a greater proportion of stocks lost money for shareholders, with around 8% of stocks a complete loss over this period. In addition, the study found that over half of the stocks failed to beat investing in short-term bonds, a very low bar in terms of real returns. However, the proportion of stocks that generated extremely good returns also increased. Around 8% of global stocks nine bagged or greater. This skewness implies that the positive mean excess returns observed for stock portfolios are driven by very large returns to relatively few stocks.

So what is the implication of these findings for the equity investor?

Practical Implications

Consider investing in index funds

One way investors can ensure they own these rare stocks that generate almost all of the long-term stock market returns is by owning the whole market. Investing is one of the unique pursuits where being average is easily achievable and perfectly adequate. Regularly contributing to a low-cost index tracker will easily beat the vast majority of active managers after costs. So, for those who don’t want to spend the time required, don’t enjoy the process of investing, or don’t have the temperament to be an individual investor, passive equity investing is a very credible alternative. However, a Stockopedia subscriber is unlikely to be happy with simply being average.

Search for the extreme outperformers

One way of outperforming over the long term is to find and own those exceptional high-return stocks. Investors can learn from the characteristics of past stocks featured in the extreme right-hand tail of returns. One such study is the 100 Baggers book by Thomas Phelps that I wrote about in this article. In order to be able to analyse these types of stocks further, I developed the following framework:

Runway - The ability for a company to grow into one with a significant scale. Ideally, a company should be able to grow its sales by 10x in real terms and preferably much more than this.

Moat - The ability for companies to resist competitors “eating their lunch”. Companies that generate a high and stable Return on Equity is a sign that they may have a suitable moat.

Operational Leverage - Companies with operational leverage, where their costs grow more slowly than their revenue, will turn sales growth into even more rapid earnings growth.

Low Multiple - Cheaply-rated companies have more scope for multiple re-ratings to add to investor returns. Conversely, an already expensive stock may still generate good returns due to sales and earnings growth but may face a headwind to returns from multiple contraction.

If investors can find companies that exhibit all four of these characteristics, they are likely to have identified a company with the potential to be one of the long-term winners.

In 2020, hedge fund Alta Fox Capital released the results of a study called ‘The Makings of a Multibagger’ that looked at the characteristics of the best-performing global stocks over the previous five years. They defined these as companies which generated a Total Shareholder Return greater than 350%. They found 104 companies that met this criterion which were also between $150m and $10b market cap, excluding energy, materials, and financials.

As you’d expect, Technology and Healthcare together made up the bulk of the high-return stocks:

And these were over-represented in the high-performance stocks in comparison to their weights in the set of investable stocks:

Investors may think this focus precludes finding very high-return stocks in the U.K. market. However, this didn’t prove to be the case. Instead, the U.K. was over-represented, and the U.S. was underrepresented:

The U.K. stocks in the study were: Games Workshop (LON:GAW) Future (LON:FUTR) £JD Boohoo (LON:BOO) Keywords Studios (LON:KWS) Frontier Developments (LON:FDEV) Ab Dynamics (LON:ABDP) YouGov (LON:YOU) GlobalData (LON:DATA) Fevertree Drinks (LON:FEVR) Bioventix (LON:BVXP) Tristel (LON:TSTL) Learning Technologies (LON:LTG) RWS Holdings (LON:RWS) IG Design (LON:IGR) Gamma Communications (LON:GAMA) and Ideagen.

However, look what happened to investor returns after the study was published:

As a set, these are anything but high-performing stocks, with 12 out of the 17 subsequently losing investors money if they bought and held. Several of these companies have lost shareholders almost all of their money since 2020. The only real bright spot was Ideagen which was taken over by private equity. (The figures above don’t include dividends, but the average of -13% capital return is significantly behind the +7% capital return of the FTSE250 over the same period.)

The subsequent performance of these previously high-return stocks, shows that finding the small proportion that outperforms over the very long term is incredibly challenging. Five years of significant outperformance typically leads to substantial underperformance, not continued outperformance. However, this gives a clue about what investors can learn from Bessembinder’s study.

The importance of rebalancing

To outperform the market, investors don't have to find the few stocks that will generate exceptional returns over a 30-year horizon.  The academic studies that the Stockopedia Quality, Value and Momentum Ranks utilise a process of periodically reforming portfolios, usually after a year. However, this is somewhat arbitrary. As this chart from the Factors from Scratch study shows, Value portfolios should see continued outperformance with holding periods of up to four years, as both EPS and multiples tend to re-rate over this period:

Momentum investors may want to rebalance more rapidly, at most after a year. The market tends to underestimate the EPS growth rate of a momentum portfolio over the following 12 months. However, this tends to be a short-term effect. Post 12 months, the EPS growth of a Momentum portfolio tends to be less than the market:

One of the learnings from my attempts to “surf” the StockRanks was that investors should be relatively quick to sell out as soon as that Momentum Rank begins to fall.

The Factors from Scratch study doesn’t contain a similar Quality factor analysis. However, logic would dictate that the Quality factor should be reasonably persistent. After all, consistently high Return on Equity is the primary definer of Quality stocks. If a company possesses a moat, it should be breached relatively slowly. Hence Quality investors may be able to rebalance at a leisurely pace, or only sell when a company no longer meets their quality criteria. However, all the academic studies are based on one-year rebalancing, so Quality investors may wish to reform portfolios yearly, rather than risk an unproven strategy.

It seems the real lesson from the long-term study of almost 64,000 global stocks is what the authors don’t say: it is a lot easier to be a successful investor by repeatedly taking advantage of the Quality, Value and Momentum market inefficiencies that exist over a period of a few years, than trying to find a stock that will be one of the few best-performing ones over the next 30 years.