Don’t Confuse Dollar Wealth Creation with Return

In his recent study entitled Do Stocks Outperform Treasury Bills?, Professor Hendrik Bessembinder of Arizona State University came to the conclusion that of the nearly 26 000 stocks listed in the United States since 1926, only 42.6% have outperformed treasury bills over their lifetimes. Further, only 4% of these companies account for all net stock market gains and roughly 0.3% of all companies account for half of these gains. So although stocks do outperform treasury bills in aggregate, more than half of stocks don’t outperform, and the vast majority of net dollar wealth creation has been concentrated in tiny fraction of listed companies.

These statistics have made headlines in investment circles for obvious reasons. Since stock markets in aggregate have beaten treasuries over most long-term horizons, people naturally assume that the same is true for most individual stocks – not so.

What is troubling, however, is some of the arguments that have been made based on this data, if not by Professor Bessembinder himself then certainly by a number of journalists, bloggers and financial pundits who have drawn their own conclusions. The real shock-and-awe number that is touted most often is “4%” – i.e. only 4% of companies account for all net dollar wealth creation. They reason that if only 4% of stocks generate all wealth, then you cannot afford to miss out on them and you should diversify as widely as possible because who on earth can reliably identify the 4%? In other words, buy the index.

We think this conclusion is deeply flawed primarily on the basis of one analytical error: Confusing dollar wealth creation with return.

A simple example demonstrates this: At number 8 on Professor Bessembinder’s list of lifetime wealth creation is General Motors Corp. It has created USD 425 billion in wealth for its investors. It’s actual % return? Just 5% per annum. Investors who missed out on this one wouldn’t have missed much. The reason it generated so much wealth is because of its size, not its performance.

To reinforce this point, consider the following: If we take the 1 000 largest stocks in our investment universe by market value, their combined market value is roughly USD 44 trillion. The next 1 000 stocks have a combined market value of roughly USD 7 trillion. If the top 1 000 earn a return of 5% next year, they will generate dollar wealth of USD 2.2 trillion. If the next 1 000 returns 10% they will generate dollar wealth of only USD 700 billion. Of the 2 000 stocks, the top 1 000 would have generated 76% of dollar wealth for the year even though they underperformed by half (or 5 percentage points). For the next 1 000 to generate as much wealth as the top 1 000, they’d need to return more than 30% next year vs 5% for the top 1 000.

The stocks at the top of the wealth creation list are there for two possible reasons: Size and/or past return. Bigger companies generate bigger dollar returns, but not necessarily bigger % returns. Investors should be concerned with the latter, not the former. There are a lot of great investments which haven’t generated huge dollar wealth because they are smaller companies. Size doesn’t make an investment good or bad, return does.

Further, the study was set up in such a way that the 1 000s of small companies with positive returns first had to compensate for the 57.4% of losing stocks before net dollar wealth creation even started adding up. This could easily be misunderstood to mean that those 1 000s of companies were also bad investments, which would be incorrect.

So although the “4%” number makes for a good story, the more relevant statistic is “42.6%” – the proportion of stocks that have outperformed T-Bills over their lifetimes. While this statistic may be surprising to some, it ties up well with our own in-house research based on the causality of return. Of the 2 500 companies that we’ve analyzed, roughly 30% are of sufficient quality by our standards to warrant investment at the right price (our bar is a little higher than T-Bill rates).

This is a much bigger target to aim at than 4% and we don’t need to hit it perfectly. We just need our estimate of the 30% of quality companies to overlap with the actual future 30% of quality companies better than the overall market does and/or to buy them when they’re well-priced. Armed with a good understanding of the causality of return and the ability to cover a very wide investment universe efficiently, we believe this is a superior approach versus indiscriminate diversification.

What to Expect from a Good Portfolio

To draw reasonable long-term expectations for the market or a portfolio, one has to understand and assess the fundamental drivers of return. Total return comes from two sources: Sustainable return and revaluation.

Sustainable return is the fundamental growth of a business (i.e. revenue growth, profit growth, etc.), including the capital returned to shareholders by way of dividends/buybacks. This fundamental growth is ultimately driven by business quality, the main determinant of which is profitability: A profitable business can reinvest its profit to grow the business or distribute it to shareholders, both of which amount to sustainable return.

Revaluation is the change in the price of the business relative to its fundamental growth. This is driven by investor sentiment rather than the underlying business. While sentiment is highly unpredictable in the short term, positive revaluation over long periods of time generally occurs from periods of undue pessimism and vice versa.

The difference between total return and sustainable return over any period is revaluation – i.e. sentiment. Because sentiment tends to swing between optimism and pessimism, it is ultimately sustainable return which dictates the direction in which total return moves over long periods of time.

A good portfolio is one with superior sustainable return, preferably acquired at an attractive price – i.e. when sentiment towards the companies in that portfolio is weak.

With that in mind, consider the following real-world portfolios: Portfolio A (a good portfolio) & Portfolio B (an average portfolio):


At first glance the above chart may seem a bit busy, but if we consider it one element at a time, it paints a very useful picture:

  1. The solid blue line represents the value of $1 invested in the sustainable return of Portfolio A 20 years ago until the end of June 2017, after inflation. Note that this line has grown more than 20x since 1997 – a fantastic history of shareholder value creation;
  2. The green line represents the real market value of Portfolio A over the same period – i.e. the total return. While the green line follows the blue line over time (i.e. total return follows sustainable return), it overshoots to the upside and downside as investor sentiment swings between optimism and pessimism. As per the earlier explanation, the difference between these two lines is sentiment;
  3. The dashed blue line shows our expectation for Portfolio A’s sustainable return over the next 7 years. This estimate is based on what we believe is a conservative combination of 3rd party analyst estimates and history;
  4. The solid dark grey line represents the sustainable return of Portfolio B, but rebased so that it ends at the same point as the solid blue line (for the purpose of making forward-looking comparisons). Note that the dark grey line starts at roughly $12, meaning one would’ve needed to invest 12x as much in the sustainable return of Portfolio B to end up at the same point as the blue line of Portfolio A;
  5.  The light grey line represents the real market value of Portfolio B, which has tracked the dark grey line over time;
  6. The dashed grey line shows our expectation of Portfolio B’s sustainable return over the next 7 years.

With an understanding of what this chart represents, we can draw some conclusions/inferences:

  1. Portfolio A has a vastly superior long-term track record of both sustainable return and total return relative to Portfolio B, not only in terms of growth, but also in terms of stability. There is a degree of survivorship bias in this (Portfolio A was selected by a process where one element of the quality analysis favours companies with a strong track record of sustainable return), but this bias is countered by a combination of conservatism (the forward looking sustainable return is roughly half of what it was historically) and forward-looking quality analysis/independent 3rd party estimates that have little to do with history. Our expectation is that Portfolio A will continue to deliver superior sustainable return over the next 7 years, as per the dashed blue line;
  2. Portfolio A is about as undervalued as it has ever been;
  3. Portfolio B has climbed significantly over the last year, but this return has been driven almost entirely by revaluation to a level last seen in 2000, despite an environment in which its sustainable return has stagnated. From this valuation it is likely that returns over the next 7 years will be disappointing for Portfolio B;
  4. While we believe that Portfolio A is significantly better than Portfolio B, it has nevertheless underperformed Portfolio B recently, even though its sustainable return has been better. This underperformance has been revaluation driven.

Clearly Portfolio A has been vastly superior vs Portfolio B over the last 20 years – any long-term investor in Portfolio A would be satisfied with the results. What is less obvious is that along the way to achieving these vastly superior results, the investor in Portfolio A frequently underperformed the investor in Portfolio B by significant amounts. Consider the following chart:


Each bar on this chart (including the blue) represents the most that Portfolio A has underperformed Portfolio B in total from a specific point in time. Where Portfolio A never dipped below Portfolio B from a specific starting point, there is no red bar (note that there aren’t too many empty spaces).

Example: Let’s assume we’d invested in Portfolio A in October 2005. By August 2006 (almost a year after our initial investment) Portfolio B would have returned 13.4% after inflation, while our Portfolio A would have returned only 3.3% – we’d have been 9% behind Portfolio B. This was the worst cumulative underperformance of Portfolio A vs Portfolio B from that starting point, which is what the blue bar in the above graph represents. Each red bar represents a similar calculation from a different starting point.

What is staggering is that despite outperforming Portfolio B significantly over any long-term period, Portfolio A has experienced cumulative drawdowns averaging -7% from nearly 70% (!) of all potential starting points. In some cases the cumulative underperformance was as much as 20%!

In the above examples Portfolio A is a static snapshot of the aggregate of all our clients’ portfolios as of 30 June 2017, excluding cash*. Portfolio B is the MSCI World Index, our benchmark.

* This snapshot doesn’t include stocks bought and sold in the past and is in no way representative of the historic performance of our clients’ portfolios, which a) haven’t been around for 20 years, and b) have changed over time.

Telling an investor to expect good long-term returns from a good portfolio is hardly ground-breaking analysis. Very few people, however, would expect the same portfolio to experience relative drawdowns averaging 7% from 70% of potential starting points, vs the benchmark index (i.e. an average portfolio). In reality, this is exactly what investors should expect from short-term returns!

What this analysis demonstrates is that short-term returns are driven almost entirely by sentiment and that they are random. Chasing short-term returns is an exercise in futility, yet this is exactly what many investors (including professionals) do.

Our goal is to achieve good returns over a 5 to 10 year investment horizon. As the first chart in this commentary demonstrates, we believe that we are well positioned to achieve this goal: We hold good quality stocks that are currently undervalued. Along the way to achieving our long-term goal we fully expect to experience periods of short-term underperformance. These two apparently conflicting expectations are entirely consistent with a good portfolio – this is one of the great paradoxes of equity investment.

The Hidden Value of Cash

When we put together a new portfolio, we always invest at least 70% into our best investment ideas, adequately spread across different industries and geographies. The stock market has been a leading source of long-term investment returns for the last century, and we don’t believe this is about to change. Further, although the market is prone to sharp drawdowns at times, we don’t believe that these drops can be timed accurately/consistently, and it is therefore better to remain invested in the stock market through thick and thin.

Why then do we not always invest 100%? Are we timing the overall level of the market? – No. Can’t we find investments with a better expected return than cash? – It depends how you view the expected return on cash.

Let’s start then, by defining the long-term return on cash. It is not equal to the current yield. It is equal to the current yield for the period that you hold it, plus the return on the asset that you invest it in for the remainder of the investment term. Example: If you invest today in something priced for 10% p.a. for a 10 year term, then the return over the 10 year period is 10% p.a. If cash earns 0% today and next year you invest it in something priced for 15% p.a. for a 9 year term, then the return on your cash is 13.4% p.a. over the 10 year period. Deciding whether or not to invest cash today depends on the probability of earning a significantly better return over the investment horizon by waiting instead.

Since we are making investments with a 5 to 10 year horizon, time is on our side, and every time we make an investment we need to decide whether it would be better to wait for other opportunities or not. This depends on a) the current yield on cash, b) how much cash we have left, and c) the expected return of the asset we are buying. Obviously a higher yield on cash demands a higher expected return on a potential investment. What is much less obvious is that the less cash we have left, the higher the expected return on the asset under consideration needs to be for us to make the investment. We’ll explain this by way of an example:

By our estimation, there are currently about 660 stocks across the globe that are of sufficient quality and are sufficiently liquid for us to invest in – at the right price. Assuming we invest 3% per position, we would hold 33 positions when fully invested.

Let’s assume that we are currently 96% invested (i.e. we hold 32 positions) and the best available investment that we don’t already hold is priced for 10% p.a. While 10% p.a. is certainly better than 0% on cash, the likelihood that at least one of the 628 remaining investments becomes priced for significantly better than 10% within the next year is very high (the probability of any 1 stock out of 628 dropping significantly is much higher than the probability of all 628 dropping significantly). Therefore the expected return of holding our last remaining cash is higher than 10% and we should rather wait for a better opportunity, even if the cash is a drag on our performance in the short term.

Working backwards from this point, it becomes clear that the more cash we have to invest and the higher the return of the potential investment, the lower the probability of beating that return over the investment horizon becomes. E.g. If we are 51% invested (we hold 17 positions), and we are considering investing in an asset priced for 15%, the probability of finding 16 better opportunities in a reasonable space of time is quite slim. It makes sense to make the investment.

At the extreme of holding 100% in cash, the implicit assumption is that there isn’t a single asset out of 660 worth buying and that you are sure to find 33 better investments than your current best opportunity quite soon. When your cash yield is 0% and the best investment opportunity is priced for 20%, the chance of this assumption holding true is very slim.

The less cash we have, the higher its expected return is, and the more valuable it is. The decision to part with our last bit of cash is not taken lightly.

When we put together a new portfolio from 100% cash, we start with our best long-term investment ideas and keep adding the next best investment until the expected return of the marginal investment opportunity is lower than the expected return implied by holding cash and waiting. Under current market conditions we estimate that this equilibrium is struck when we are 70% to 80% invested. We believe that holding the remainder in cash and waiting for better opportunities is likely to deliver a better return over 5 to 10 years than what could be earned by investing in the next best opportunity today, even if cash is a drag in the current market.

The Problem with Forecasting

The most notable event of the 4th quarter was Donald Trump’s unexpected election victory – a victory that was supposed to send global markets crashing down. Instead markets have rallied strongly into the end of the year, much to the surprise of pundits everywhere.

This apparent contradiction highlights a very important aspect of investment philosophy: One can attempt to predict the future and invest accordingly, or one can seek to identify companies which should do well through a range of future conditions.

Investing on the basis of future predictions is problematic for two reasons:


1) No one seems to be able to predict the future with any consistency, not even the experts:

The recent Brexit vote and the US election are perfect examples. No one in the news media or the financial markets gave Leave/Trump a chance of winning. I wasn’t expecting either outcome (though we also hadn’t “positioned” for any specific outcome). I distinctly recall watching an expert on one of the major news wires explain how anyone giving Trump a chance of winning didn’t understand the Electoral College system, and even if Trump won the popular vote, he had no chance of winning the electoral vote. He could not have been more wrong.

The same is true for predictors of market crashes. Not a day has gone by since the last market crash that someone hasn’t penned an article predicting the next one right around the corner. Notably, at the beginning of 2016 RBS came out with a recommendation to sell all risk assets as 2016 was to be a “cataclysmic year”. The MSCI World Index rallied 12.5% in USD from the date of publication through the end of the year.

Make no mistake, there will be market crashes in the future, as there have been in the past – we just don’t know when. Market crashes are the result of collective investor sentiment turning very sour, very fast, and as such are inherently unpredictable. In his recent blog post on market crashes, Ben Carlson writes, “I have no idea how I will personally feel tomorrow morning. How will I ever be able to predict how millions of other investors will be feeling one week, month, year or decade from now?”

Most of the people who make these predictions are highly intelligent – but they are trying to predict the unpredictable.


2) Even if one predicts the future correctly, markets don’t always react as anticipated:

Both Leave and Trump victories were expected to be disastrous for global markets, and indeed the initial market reactions seemed to confirm this. In the aftermath of both outcomes markets pulled back heavily (the S&P 500 futures were limit down in Asian trading following Trump’s win), only to recover within 24 hours. With the notable exception of the Pound, most assets have strengthened since both votes.

Imagine having correctly predicted these outcomes and sold everything accordingly, only to have the markets go the wrong way? What do you do then?

A similar outcome occurred in South Africa in 2016: That it would be a year filled with political risks was not difficult to predict, but few would associate that with a strengthening Rand and the outperformance of Rand-based assets.

Of course there have also been numerous cases where markets have reacted as one might have expected: Lehman Brothers, Greece, etc., but this is often not the case.

The point is that market reactions to future events are almost as unpredictable as the future events themselves.


The alternative approach is to focus on the causality of investment returns and invest in assets that are likely to deliver good long-term returns under a wide range of outcomes. The causality of returns is clear: Quality and price.


A diversified portfolio of consistently profitable businesses, with strong financial positions is likely to deliver good sustainable return over time, through the inevitable thick and thin. Buying these companies at low valuations is likely to further enhance this return over time, as negative prevailing sentiment generally turns positive again at some point, resulting in higher valuations.

So why doesn’t everyone do this? Why do so many experts invest on the basis of predictions?

1)         Predictions tend to be more rooted in stories and narratives, which are far more exciting, intuitive and emotionally compelling than a handful of numbers which often contradict our prevailing emotional sentiment;

2)         News media is in the business of selling sensation and short-termism, which fits nicely with extreme predictions of the near future – so this is all we ever see;

3)         Because there are so many experts predicting every possible outcome every day, it is easy for news media to lend these people credibility by bringing them into the spotlight when their predictions happen to come true – they cherry pick the winners after the fact;

4)         Long-term Investing on the basis of causality rather than short-term stories requires emotional discipline. It often contradicts what we are told by experts on the news all day every day. It’s surprisingly difficult to cut out the noise and stick to a logical process;

5)         There is no investment process in the world that doesn’t underperform at times. In the short-term investment returns are almost entirely sentiment-driven, and no one can plot the path that sentiment will follow. It is at exactly these times that investors tend to abandon their process in favour of whatever story has worked out in the recent past. As difficult as it can be to stick to a logical process, it is even more difficult to do so when short-term results are disappointing.

(This is by no means an exhaustive list of reasons. There are many others.)

Sadly, far too many investors get caught up in stories and short-termism, abandon their process (though many don’t have a process to start with), and their long-term investment returns suffer as a result. The endless quest to time the tops and bottoms of stock markets is a perfect example.

Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

In our view, the best approach is to invest in a diversified portfolio of good businesses at good prices, ignore the noise and the unpredictable swings of the market and allow the force of compounding to do its work as the years roll by.

Diversification – A Balancing Act

Diversification is quite simply the spreading of one’s investment across a range of assets, the goal being to reduce investment risk. Contrary to popular belief, diversification is a balancing act rather than a free lunch.

To understand our approach to diversification, one first has to understand what drives investment return:


The goal of investment is to earn a good return. Return = Yield + Capital Appreciation (what you receive in dividends plus the change in share price). Capital Appreciation = Growth + Revaluation, i.e. the fundamental growth of the business (measured in terms of revenue, profit, book value, etc.) and the change in the share price relative to the fundamental value of the business. Therefor Return = Yield + Growth + Revaluation. This is a mathematical identity that always has to be true. Yield and Growth are driven by business fundamentals – a good business can pay dividends and grow its revenues and profits year after year. This is a sustainable source of return, and is driven by business quality: Quality -> Sustainable Return = Yield + Growth. Revaluation on the other hand is driven by investor sentiment. As investor sentiment swings between optimism and pessimism, so the share price of a company relative to its fundamental value also swings. While investor sentiment tends to cancel itself out over very long periods of time, it is still a very significant driver of return over 5 – 10 year periods.

In a nutshell, the causality of return is business quality and price paid. To earn a good return over the long-term, we must invest in high quality businesses at attractive prices – nothing less, and nothing more.

So where does diversification come into this?

Unfortunately even the best quality businesses can fail (though they are far less likely to do so than inferior businesses) because of unpredictable events beyond their control: Natural disaster, fraud, expropriation, war, economic depression, etc. Alternatively, a once great business can deteriorate if it fails to remain competitive and adapt over time.

Fortunately, as often as things can go wrong, or businesses can disappoint, so too things can go right and businesses can exceed expectations. A company can be the subject of a buyout at a large premium, or can have a run of success beyond all expectations.

In contrast with the predictable direct causality that Quality and Price have on return, these positive and negative surprises are highly unpredictable. This means that in a completely undiversified portfolio, success or failure may have more to do with luck and randomness than quality or price. In a diversified portfolio, these surprises are more likely to cancel out to a degree, meaning that the outcome is more likely to be a result of quality and price – the things that a good investment process should focus on.

Rather than allowing luck to have an undue influence on our portfolios, we prefer to minimize the role of randomness and maximize the role of our investment process over time through a reasonable degree of diversification. The goal is to diversify away as many sources of randomness as possible (i.e. geography, industry, company, currency, etc.) without diversifying away the causality of superior long-term return (i.e. high quality at an attractive price). The second part of that last sentence is critically important and often forgotten. The best portfolio is probably one where the only common thread is quality and price. When this balance is not possible, it usually isn’t worth pursuing diversification at the expense of expected return.

All too often investors diversify so extensively, without any consideration for quality or price, that the long-term expected return of a portfolio declines rapidly as the two fundamental causes of superior return are diversified away completely. Sadly, this is the approach taken by many investment advisors: They neglect the fundamental causes of superior return by spreading their clients’ investments across a wide range of costly strategies in the pursuit of diversification, only to end up with an expensive index tracker. This is certainly not our approach.

It is worth noting that insofar as achieving healthy diversification whilst maintaining expected return is concerned, it is better to have a broad investment universe rather than a narrow one. While 25 – 40 stocks might sound like a lot, a portfolio of 40 stocks from an investment universe of 5 000 + stocks listed across the globe is likely to be far superior (better diversified, with a higher expected return) when compared to a more concentrated portfolio selected from a narrower universe of stocks. This is why we take a global view: We can achieve wide diversification, but still only invest in the top 1% of companies ranked by quality and price.

The Importance of Liquidity

When we first meet new clients, we like to take them through a presentation of our process so that they can understand how we manage their portfolios and what to expect over time. At the beginning of this presentation, we briefly discuss the importance of things like costs, transparency, alignment of interests and liquidity. While most of our presentation is dedicated to process, these 4 points are extremely important when assessing a potential/existing investment, and are often underappreciated and misunderstood by investors.

Liquidity in particular is something few investors really understand and only learn to appreciate when they need to access their money. Imagine being invested in something for years and earning good returns on paper, only to learn that you cannot realize these returns when you ask for your investment to be redeemed. There are many reasons this could happen: Lock-ins, no active secondary market, illiquid underlying assets, etc.

Perhaps one of the most significant casualties of the Brexit vote so far has been the UK property market. The UK REITs index (i.e. listed property) has dropped by nearly 30% in USD terms since 23 June. REITs are generally quite liquid because they are listed on a stock exchange and so there is an active secondary market. Physical property and unlisted property investments on the other hand are far less liquid, which can result in problems when investors need to access their funds.

An example of this has become apparent in the last few days as 3 well-known UK property funds have had to suspend redemptions because of insufficient liquidity: Standard Life, Aviva and M&G Investments have all suspended redemptions from their property funds so that they can liquidate their underlying assets in an orderly fashion. Unlike listed REITs where investors can sell their units into an active secondary market, these funds have to fund redemptions from their underlying assets. Because their underlying assets are properties they usually take time to liquidate (it’s not so easy to find a buyer for an office block or a mall, especially now in the UK). Usually redemptions aren’t an issue for these funds because their investors aren’t all liquidating at once, but when redemptions peak they simply can’t satisfy them all at once.

The same problems can arise in hedge funds with complex structures that take time to unwind, and with private equity funds that have highly illiquid holdings in unlisted private companies. These funds usually feature lock-in periods and/or notice periods, though they have also been known to trigger suspension clauses in a number of cases.

Liquidity then is a critically important consideration when making any investment – something many investors only discover too late, and to their detriment.

That’s not to say that these funds can’t be good investments – they can – it’s just important that investors understand the liquidity profile of their investments upfront, so that they can make sure they have sufficient liquidity in their overall investment portfolios.

Our clients’ portfolios are only invested in highly liquid listed assets with very active secondary markets. They are free from complexity and are completely transparent. This means that liquidity risk is very low.