Here’s one piece which highlights the merits of active investing and yet shows why it is so hard to generate alpha. Baillie Gifford, a Scottish investment management firm pursues strong collaborative ties with the academia to stay ahead of the curve. In one such piece, James Anderson, a partner at BG, writes about research from Prof Hendrik Bessembinder of Arizona State University who highlights that most stocks fail to beat treasury returns implying equity returns tend to be concentrated across a handful of stocks. So, the lure of active investing is the disproportionate gains from the winners, if you are lucky to find them that is, given the probability is akin to that of finding a needle in a haystack.
“In early 2017 Professor Bessembinder released his initial drafts of a paper entitled Do Stocks Outperform Treasury Bills? The title itself is heretical. It is a central assumption of Modern Portfolio Theory as taught to all students that because equities are more risky they must have higher rewards. But Bessembinder showed that “slightly more than four out of every seven common stocks have lifetime buy-and-hold returns, inclusive of reinvested dividends, of less than those on one-month Treasuries.
….“When stated in terms of lifetime dollar wealth creation, the entire gain in the US stock market since 1926 is attributable to the best-performing 4 per cent of listed companies.”
…But if this is right then our task is transformed. Our job is solely and simply to find and invest in the stocks that are capable of producing the extraordinary returns of the 4 per cent. Everything else is best put aside. But what characteristics might the companies need to produce these returns? What attributes in turn do we need to hope to identify them? As Bessembinder writes, “The returns to active stock selection can be very large. If the investor is either fortunate or skilled enough…”
Whilst going on to highlight patterns such as great founder-owners who were early in a market which would go onto become large as typical characterstics of such companies, he also helps us with cues about how investors can identify such companies. Most importantly, if only a few companies create all the value, he emphasises on the need to stay invested in such compounders over long periods of time and resist the temptation to ‘book profits’ which creates reinvestment risk:
“…What is more striking and even more exciting is the attributes that the Professor believes that investors in their turn need to possess in order to identify the truly great potential companies. Just like the company founders themselves he thinks the skills we need are centred on dreaming of a grand future, backing great people and coping with twists and turns and ups and downs.
His explication seems to us to run very counter to the perceived market wisdom. It certainly casts doubt over the strong preferences of most investors for predictability and certainty. But still more his perceptions indicate that our job is much more about the imagination of the future that can envisage brave new worlds and the qualitative assessment of leadership skills than about the hard analytic numbers and confident financial mastery that the 227,031 are being examined on for the CFA. So to us the hope – or inspiration – that Professor Bessembinder provides is that as our financial industry marches firmly and unanimously up one hill, we’re running determinedly in the opposite direction. If we are right that is a compelling competitive advantage.
But there’s one last essential to the Professor’s current thinking. Identifying the great investments isn’t enough. As Hendrik Bessembinder makes plain it is the long-term compounding of their share prices that matters. This seems to us to require an additional set of skills such as the creativity to imagine greatness discussed above. The compelling urge amongst ordinary humans for sure, but far more damagingly amongst that odd sub-breed that are fund managers, is to take profits and lock in performance. As the old saying goes: ‘it’s never wrong to take a profit’. But it is often not just wrong but the worst mistake that can be made. Professor Bessembinder is reinforcing such convictions.”
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