Michael Mauboussin and Dan Callahan have come up with another brilliant paper building on the now famous research by Hendrik Bessembinder which showed that a handful of companies i.e, 2% of all listed companies were responsible for more than 90% of wealth creation. The authors take this concept and link to longevity of companies (a concept central to the Marcellus investment philosophy) and show how wealth creation is not just returns but returns compounded over extended periods of time.
They show that this has implications for portfolio construction:
“The data on wealth creation suggest two strategies for portfolio construction. One is to recognize that an investor can capture the skewness, or asymmetry of a distribution, in long-term total shareholder returns by holding a diversified portfolio. Index funds are an effective way to implement this approach. While an index will include stocks with poor returns, it will also have the handful of companies that generate most of the aggregate value.
The other strategy is to build a relatively concentrated portfolio that seeks to include the companies that have the potential to generate high returns and avoid those that do not.”
At Marcellus we prefer the latter.
But identifying such a small set of wealth creators is hard enough, holding on to them is even harder.
“Active managers seek to capture a sliver of the wealth generated by the best-performing public companies. Doing so is obviously difficult, but Bessembinder studied the set up and characteristics of the top wealth creators.
Here is some of what his work revealed:
• Stock price drawdowns: The stocks of the best wealth creators over time went through substantial drawdowns, a measure of the decline in a stock price from the top to the bottom over a particular period. For example, Apple, which created nearly $2.7 trillion in wealth from its IPO in 1981 to the end of 2022, suffered three drawdowns of 70 percent or more over that span. These included 74 percent from May 1983 to August 1985, 80 percent from February 1992 to December 1997, and 79 percent from March 2000 to March 2003. Apple was the top wealth creator through the end of 2022, but most investors would have struggled to hold the shares through these declines. The shares of Amazon offer another case, having suffered a drawdown of more than 91 percent from February 2000 to September 2001 on their way to being among the best wealth creators.
• Not just technology. While companies in the information technology sector may come to mind first when considering the top wealth creators, Bessembinder found that these companies were underrepresented among than the best. Sectors that were overrepresented among the winners included healthcare and energy. Industries with high variance in return on invested capital tend to be represented among the top and bottom groups in wealth creation.
• Common characteristics of the winners. Bessembinder considered a slew of financial metrics to assess which ones, if any, were consistent with substantial wealth creation. Large increases in net income, rapid asset and sales growth that the company generated internally, a rising return on assets, above-average research and development (R&D) spending, and cash accumulation were among the characteristics of the top wealth creators. An investor can measure these characteristics objectively, and they may help anticipate good and bad prospects for wealth creation”
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