Fancy yourself as a good stock-picker? Think you can spot the next big thing and avoid tomorrow’s losers? Think again.
A recent JPMorgan report highlights just how difficult stock-picking is, with two in every five stocks typically suffering terrible losses from which they never recover.
The report, The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position, shows stock-pickers are much more likely to experience the agony rather than the ecstasy. Since 1980, 40 per cent of stocks in the Russell 3000 – an index that captures 98 per cent of the US equity market – suffered a "catastrophic" decline in share price of 70 per cent or more.
"We are not talking about temporary declines during the tech boom-bust or during the financial crisis," writes Michael Cembalest of JPMorgan, "but large, permanent declines that were not subsequently recovered".
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Additionally, 40 per cent of stocks have delivered negative returns over their entire lifetime, the report found, and two-thirds of stocks in the past 34 years have underperformed the index.
Index investors, of course, have done just fine since 1980, despite so many stocks turning out to be losing propositions. That’s because about 7 per cent of stocks go on to become “extreme winners”; the gargantuan returns earned by companies like Apple, Amazon and Starbucks driving the overall market to healthy gains.
If you'd loaded up on such stocks, you would have made a bundle. You may even have profited by investing in some of the stocks that suffered catastrophic declines, a number of which also end up in the category of extreme winners. Cisco, for example, has returned 27 per cent annually over its lifetime, despite having lost more than three-quarters of its value since 2000.
However, stock-picking would have proved costly for most investors, with the return on the median Russell 3000 stock 54 per cent less than that of the overall index. Some 75 per cent of concentrated stockholders would have benefited from some degree of diversification.
Technology losses
While investors in growth stocks often gravitate to the technology sector in the hope of finding the next Apple or Google, they are much more likely to end up losing their shirt.
“The story of the tech sector is a long narrative about disruptive technologies which are themselves disrupted by changes that follow,” says Cembalest.
Almost 60 per cent of all technology companies suffered a permanent decline of at least 70 per cent; 6 per cent turned out to be extreme winners; more than half generated negative returns; 70 per cent underperformed the overall stock market.
Wealth destruction was particularly acute after the dotcom bubble burst – of 212 internet and software companies in early 2000, only 17 ever saw higher stock prices over the following 14 years.
Might the dotcom crash distort the overall figures? No – even if you excluded all technology, biotech and other companies that went public between 1995 and 2000, the report found, the median return is still negative; the percentage of companies underperforming the index is still about two-thirds; just 7 per cent of stocks are extreme winners. Success and failure rates are similar across most sectors.
Furthermore, while loss rates rise during recessions and market corrections, there is a “steady pace of distress even during economic expansions”.
Underlying reasons
Some companies end up losing out to the technological innovations of competitors, while others bring trouble upon themselves. Companies are liable to overleverage themselves near the end of a business cycle; the report also found many cases of mismanaged acquisitions, as well as management “misreading rapidly changing industry dynamics and competitive factors”.
However, investors should resist the cosy narrative of “good” and “bad” companies, of predetermined triumph and failure. Often, outside factors drive company fortunes.
A company may find its position usurped by foreign competitors backed by government subsidies and exchange-rate manipulation. Governments may change policy in carbon tax regimes and fracking rules, or make changes in the interpretation of antitrust rules, or trade policy changes, or industry deregulation or reregulation, or commodity price risks – or innumerable other drivers of change.
All too often, it is “not clear that even the best management teams in the world could have done much to alter the ultimate outcome”.
Similarly, the so-called “ecstasy stocks” are a “very heterogeneous” bunch, with no obvious way of spotting them in advance. Some generated huge wealth over many decades; others did so in a few short years. Some, like the aforementioned case of Cisco, have been money-losers for many years, but experienced huge growth in the 1990s.
“If history is any guide,” the report cautions, “the drumbeat of business distress . . . will eventually ensnare some of them.”
Investing implications
There are obvious implications for investors. Clearly, stock-picking is extremely difficult, given so many stocks go nowhere while only a handful generate outsized returns. Doing extensive homework may be of limited help: “No matter how well you know your industry and your company, no one is impervious to event risk and industry changes,” Cembalest says.
Accordingly, the case for a diversified portfolio is self-evident. Irish investors should be well aware of this. In 2005, it was estimated that managed funds in Ireland were allocating 25 per cent of total equity to the Irish market, setting the scene for enormous wealth destruction in the coming years. Unfortunately, many remain blind to the benefits of diversification: a recent Barclays report found that just 36 per cent of wealthy Irish people had a geographically diverse portfolio of assets – less than any of the other 17 countries surveyed.
JPMorgan’s report also suggests business risk in the technology sector may be rising, judging by the spate of unprofitable technology companies going public in 2014. So far this year, just 20 per cent of technology companies going public have been profitable at issuance – a level unseen in history, excluding the all-time low of 14 per cent recorded in 1999 and 2000.
Luck and risk
The perils of the stock-picking game tend not to be elucidated in the mainstream media. Analysts assert why such-and-such a stock will outperform, safe in the knowledge no one is keeping score.
As well as that, commentators tend to downplay the importance of luck and risk control in the investment process, as exemplified in the infamous case of US fund manager Bill Miller.
Hailed as one of the greats after beating the S&P 500 for 15 straight years between 1991 and 2005, Miller liked to double down on losing bets. He would continue to buy more as his stocks plummeted, stopping only, as he once said, "when we can no longer get a quote".
The approach proved catastrophic during the global financial crisis, when Miller bet the farm on stocks such as Fannie Mae and Bear Stearns. His fund fell 55 per cent in 2008 and ranked last among 1,187 US large-cap equity funds over the 2006-2010 period.
Taking a concentrated approach can work, of course. It did for Miller for many years, and also helped "drive the success of all 10 of the top 10 on the Forbes magazine list of world billionaires in 2014", says Cembalest. For the vast majority of stock-pickers, however, the odds are stacked against them.
