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.