Less than 5% of companies drive all market returns.

Understanding the fact that less than 5% of companies are responsible for all returns above bonds is crucial for investors. Research by Hendrik Bessembinder reveals that 58% of stocks fail to outperform bonds, 38% beat bonds modestly, and just over 4% of stocks drive overall market returns above bonds. Out of this 4% a further 0.5% were responsible for half these returns.

This statistic doesn’t mean that only 5% of companies are successful, but rather that less than 5% achieve long-term success. So, the challenge for investors is to identify these top performers. It’s a tough task, which is why diversification to balance risk and capture overall market returns is important. Active investors face the daunting challenge of separating winners from underperformers amidst a large pool of companies.

This study provides valuable insight into the difficulties of being an active stock picker. It’s not meant to discourage investors, but to underscore the importance of everything discussed in the investing education section. In my experience, about a quarter of companies perform well. Therefore, while less than 5% are responsible for all returns, the focus is really only on the companies that have survived. After all, significant returns have been generated by companies that no longer exist.

What does all this mean for investors?

There are a lot of ways to interpret this data. The most important takeaway is:

Broadly Diversify your portfolio.

or

Concentrate on high-conviction ideas.

If you don’t believe you can find the 5% of winners, then it’s best to diversify or follow a passive investing approach. Rather than getting excited about trying to find the 5%, think about this: half of companies perform worse than lower-risk investments such as bonds, and only a fraction less than this will provide okay returns.

The lifespan of companies listed is also diminishing with the average lifespan of 7.5 years. This does not take away from the fact that some of these businesses did generate returns until they started to decline. Even in my short 15-year journey, I’ve generated significant returns on companies that are no longer listed.

Another key lesson is what you DON’T invest in is just as important as what you do. Saying NO to a lot of rubbish companies can help investors narrow down and focus on the most compelling ideas. I’ve found that in my filtering for investment ideas, less than 5% are investable. However, that is largely shaped by my investment criteria.

If you loosen your criteria, more companies filter through. I’ve sifted thousands of companies across different exchanges, and the truth is the majority are rubbish businesses that have no future. So, while I resonate with the idea that less than 5% of companies make for good investments, it is not about thinking the task is impossible.

It is reinforcing the idea of a rigorous investment process, having a philosophy and a strategy that can naturally distil down the 60k+ public companies to the best ideas that can provide returns above low-risk investments.

Another way to look at the results…

The study reveals that a few successful investments heavily impact the overall results. However, the truth is that there are many more winners, and the results are significantly affected by the existence of underperforming investments, which brings down the overall percentage of winners over time. The report emphasises the importance of long-term investing, but the reality is that there are many short-term winners that generate returns, ranging from one-year to several-year holding periods.

If it were as simple as identifying billion-dollar companies when they were small and holding onto them, we’d all be wealthy, and I wouldn’t need to write about this topic.

Although we all strive to invest for the long term, it’s rarely the case.

The study highlights the companies that not only thrive but also survive. However, it’s important to note that not all investing success is achieved through buy-and-hold strategies. Opportunities such as undervalued stocks, high growth potential, and other profit-generating prospects are not addressed in this observation.

From a buy-and-hold perspective, this is indeed an important concept. Personally, and many investors like me, make money not just from long-term holdings (10+ years); while it’s the overall strategy to find winners, we also execute short-term positions (1-5 years) and don’t always hold onto our investments until they become mega-successes.

Although I intend to hold investments forever, it rarely happens linearly. Turnover can be high at times, and some investments may resemble short-term trades with holding periods of a year. The best investors are flexible. The market presents investment opportunities every day.

If I spot a temporary divergence between price and value in a business and believe it will be corrected within a year based on my investment thesis and research, I take a position. I wait for the thesis to be executed and reevaluated, and then I sell. I do this quite often. Similarly, with a growth business that I believe is entering hyper-growth and may experience several years of excellent growth, resulting in a consistently increasing share price. When the growth stabilises, I exit.

The report leaves out strategies that rely on the rerating of the share price.

All of these investment strategies may not be reflected in these types of results. Most hedge funds and investment funds, while focusing on the long term, also capitalise on short-term opportunities. Our goal as private investors is to allocate our capital to the best asymmetric opportunities, regardless of whether the holding period is 1 year, 10 years, or 50 years.

I’ve found that a lot of long-term investors who profess this to be the best strategy rarely hold long-term themselves. It’s not because they don’t want to it just highlights the challenges of finding companies worth holding onto. I hold until my thesis breaks and the risks I’ve identified start to become evident. In the small-caps companies break all the time, that is the reality, or it gets taken over.

I’ve held a few investments over a decade and they have provided some great results. However, some of my best returns were on much shorter holding periods of 1-3 years when I saw an opportunity, backed up the truck, conducted significant due diligence and then patiently waited for the plan to play out.

Some would say you are trading because you are not holding long-term. I disagree. Any financial decision backed with solid research (not chart reading) and a clear exit strategy that indicates that profit is highly likely, is investing.

Investing is the clear allocation of capital based on sound fundamentals to generate a profit. Nowhere in history does it say investing is only classified by a holding period of X?

In Summary…

I want to emphasize that while there are few long-term winners in investing, having a few big winners can significantly improve overall performance. This blog focuses on active investing, so the lessons lean towards this approach. The study strongly supports the idea that for most investors, diversification is the best way to capture overall returns.

However, to truly achieve superior returns, an investor should concentrate on the most compelling asymmetric investment opportunities. This report indicates the challenges active investors face but also demonstrates why focusing on identifying high-quality businesses long-term potential can lead to exceptional returns.

The most effective way to find those big winners is through a repeatable and systematic approach to investing. Minimising failure rate over time is a crucial aspect of the process i.e. Saying no more often. While it may result in missing out on a few short-term winners, it maximises the ability to identify companies with the best chance of long-term success.

🖼️ What is the cover image? The illustration shows an original Roman Crane that did all the heavy lifting in the old days. Just like the select few companies that do all the heavy lifting providing overall returns.