So, another year begins, writing about shares. I can’t say “over my 35 years as a finance and investment journalist,” because the biggest lesson is one that I have really only learned in the last two years.
It is finally realising the extent of the corporate carnage on the share market.
Of course, I knew that listed companies can fail, and spectacularly, immolating shareholders’ money (although you can use a capital loss to offset a capital gain, even a complete loss; the website Delisted.com.au operates an excellent service that effectively acquires your shares in collapsed companies, allowing you to claim the capital loss to put to work in your tax return.)
But I did not realise how many companies do collapse.
In 2019, advisory firm Stanford Brown crunched the Australian numbers and estimated that the 2,300 companies listed on the ASX represented just 6% of the companies that had raised from investors and listed on an Australian stock exchange since the early 1800s. Moreover, only an estimated 580 of those listed companies were making money — meaning that only about 1.5% of all the companies that have ever listed on the share market in Australia managed to survive and build a profitable business.
Where did the 94% of companies that had not survived go? Stanford Brown estimated that up to 1,000 of them, or about 3%, were taken over by other local companies. Another 200 or so were taken over by foreign companies. The rest simply failed and disappeared or were mopped up at very low prices.
But that handful of survivors must drive the index return over the long run.
It’s a similar story in the US, where a 2018 study by Hendrik Bessembinder of the Department of Finance at the W. P Carey School of Business at Arizona State University looked at the US stock market between 1926 and 2016 in terms of shareholder wealth creation (which the study defined as generating a return above that which could have been achieved by investing in US Treasury bills (short-term bonds).
The study found that the top-performing 1,092 listed US companies (or 4.3% of the total number of listed stocks during this time period) accounted for all the wealth creation from investing in equities (that is, excess equity returns relative to treasury bills). In 2019, Bessembinder replicated this study across 42 countries over the 1990 to 2018 period, and he found that the returns globally were even narrower — the best-performing 811 firms (or 1.3 per cent) accounted for all the net global wealth creation in shares. The rest just earned what T-bills did.
It gets worse — in a 2020 update, Bessembinder found that just 83 companies (0.3% of the total) accounted for half of the lifetime shareholder wealth creation of US$47.4 trillion ($70.7 trillion) in the US stock market between 1926 and 2019. Just five companies (Apple, Microsoft, Exxon Mobil, Amazon and Alphabet, Google’s parent company) accounted for 11.9% of the total gain.
(Speaking of this group, on Friday, Microsoft overtook Apple as the world’s most valuable publicly traded company, with a market capitalisation at Friday’s close of US$2.89 trillion [$4.31 trillion], versus Apple’s US$2.87 trillion [$4.28 trillion]. Both companies are worth more than 2.5 times the entire Australian share market.)
In other words, all that we have come to think of as “the return from the share market” – that is, about 10% a year for nearly the last century in the US, as measured by the S&P 500 index, and about 11.7% a year for the S&P/ASX 200 index and its predecessors – actually comes from an extremely narrow group of stocks. The ‘survivor bias’ is huge.
Therefore, many — if not most — of the 2,200 companies currently listed on the ASX will probably end up worthless. When investors talk about indices, they’re talking about indices made up of the listed companies that are investment-grade, which are a minority.
It also follows that the corporate survivors can do amazing things, in terms of generating wealth; but that potential is not always clear before the process kicks into gear.
Which brings me to another lesson, which goes hand in hand with the first one: just how difficult it is to identify winning stocks.
As a Switzer writer, I am always trying to do this.
The best place to see this is the semi-annual S&P Indices Versus Active scorecard, better known as SPIVA, which is a research report from S&P that compares, in any market, the performances of actively managed funds to their appropriate benchmarks.
SPIVA unequivocally shows that most active fund managers – the ones whose businesses are predicated on using the skill, expertise, and insights of their teams of mega-paid analysts and portfolio managers to produce returns better than “the market” – actually tend to underperform their benchmark, most of the time.
SPIVA’s 21-year scorecard shows that, around the world, in both investment categories and regions, the underperformance rate tends to increase with longer time horizons. When certain fund managers outperform in a certain category, the outperformance does not persist, and it does not increase the odds of outperformance in a future period.
For example, the most recent SPIVA Australia Scorecard, dating from 30 June 2023, shows that 55% of Australian Equity general funds underperformed the S&P/ASX 200 in the first half of 2023.
But over five years, 81% of funds under-performed; over ten years, it was 79%; and over 15 years, it was back to 81%.
Midcap and small-cap funds did a bit better: “only” 48% of funds underperformed the benchmark in the first half of 2023. And 64 per cent of these funds underperformed over five years, increasing to 76 per cent over ten years.
The SPIVA numbers have come to be seen as the de facto scorekeeper of the ongoing active versus passive debate, which for the retail investor should not be an either/or question; both approaches should be part of your armoury. I’d like to think retail investors have a healthy allocation to direct shares – which, of course, many do, particularly where tax-effective dividend income is concerned – and to active managers, of which, in any category, there are some exceptionally good fund managers available to help retail investors’ portfolios.
But the inevitable conclusion from my two big investment lessons is that the exchange-traded funds (ETFs) that offer broad index exposure to the major world share markets should be the bedrock holdings of the equity allocation of any retail portfolio.
Sure, these funds will often own companies that are actually destined for the junkyard; but they will also own the future survivors, too. And they will capture for investors the returns that these survivors generate.
We are seeing this in real-time, with the “Magnificent Seven” – Apple, Alphabet, Microsoft, Amazon, Meta, Tesla and Nvidia – driving nearly all of the return of the US share market. This is raising concerns of “concentration risk” – but maybe, a handful of stocks doing the heavy lifting of generating the market return is simply the norm.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
