Although we have a lot more enthusiasm for academia than broker pronouncements it's rare that one piece of research has the power to undermine an entire industry. Yet this has happened in 2017. It's just that the lemmings haven't yet realised that they are in mid-air.
The research in question is Hendrik Bessembinder's 'Do stocks outperform Treasury Bills?' We all know the answer should be yes as stocks carry significantly more risk. So, of course, the factual answer is no. Most stocks underperform 3 month T-bills. The excess return of the US stock market since long ago (1926) is entirely the result of the extraordinary lifetime performance of just 4% of the equities quoted during that period. Our own suspicions and research have long pushed us to the view that investing is a game of extremes but we confess that we had not grasped anything like the full extent of the phenomenon.
The excess return of the US stock market since 1926 is entirely the result of the extraordinary lifetime performance of just 4% of the equities quoted during that period.
But amazement is insufficient. If the findings can be confirmed for the US and replicated elsewhere then we need to review and declare redundant the principles of modern finance. Equally the fund management industry ought to reconsider its aims and methods. If there is no relationship between risk and reward either between assets classes or within equities then the Capital Asset Pricing Model (CAPM) and all its derivatives are complete hokum. As another fine research paper put it last year 'Is it ethical to teach the CAPM?' It plainly isn't. This won't have the faintest impact on the CFA Institute which will continue raking fees in and claiming the authority to determine who is qualified to be an investor for teaching - let's be frank- a bunch of lies that have little or no support in reality. They and others appear to believe that theory matters more than evidence in allocating trillions of investment dollars.
But it's not 'just' a philosophical issue. If returns are dependant on a very small number of exceptional stocks that compound for decades then an active fund manager surely has to concentrate on early identification of these superstar investments rather than constructing a broadly diversified portfolio at some level of volatility risk relative to an index as propounded for the last 50 years.
We ourselves are in the comparatively reassuring position that the search for almost unlimited asymmetric upside has been our main preoccupation.
We ourselves are in the comparatively reassuring position that the search for almost unlimited asymmetric upside has been our main preoccupation. It seems as if the 4% of companies that have produced the total return of the market have a degree of shared characteristics with each other and with the type of stocks that interest us. High, and initially underestimated growth, competitive moats and longevity are critical. It may be that long lives are even more critical than we have comprehended - but only if returns are high enough to make for well above cost of capital permanent prosperity rather than everlasting mediocrity. But we should consider ourselves fortunate: we may have to adjust our process but for most the foundations of their investment world have been up-ended. The response will be fascinating. A lack of a response would be damning.
The views expressed in this article are those of the author. Its express purpose is to highlight areas of intellectual thought and debate which inform the investment philosophy that underpins Scottish Mortgage, in the hope that they may be of wider interest. The author(s) therefore make(s) no suggestion that this article constitutes independent investment research and it is not subject to the protections afforded to such.
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