Research shows most stocks haven't outperformed T-bills

Institutional investors need no reminding of the importance of picking the right active equity manager, as they seek out stocks that can deliver alpha. But a research paper examining skewness in stock returns further drills down on this point, and even goes a step further, casting doubt on the assumption that most stocks will outperform bonds in the long term.

In fact, the paper written by Arizona State University professor Hendrik Bessembinder, "Do stocks outperform Treasury bills?" found that, among approximately 25,300 companies that issued stocks in the Center for Research in Security Prices database from 1926 to 2016, only five companies accounted for 10% of shareholder wealth creation.

"When focusing on stocks' full lifetimes (from the beginning of the sample in 1926, or first appearance in CRSP, through the 2016 end of the sample, or delisting from CRSP), just 42.6% of common stocks, slightly less than three out of seven, have a buy-and-hold return (inclusive of reinvested dividends) that exceeds the return to holding one-month Treasury bills over the matched horizon," the paper stated.

The thousands of companies Mr. Bessembinder analyzed were collectively responsible, as of December 2016, for nearly $35 trillion in lifetime shareholder wealth creation, defined in the paper as "the accumulation of market value in excess of the value that would have been obtained if the invested capital had earned one-month Treasury bill interest rates."

While five stocks — Exxon Mobil Corp., Apple Inc., Microsoft Corp., General Electric Co. and International Business Machines Corp. — accounted for 10% of total wealth creation, around 4% of the compa- nies analyzed, or 1,092 firms, accounted for all of the net wealth creation, according to the paper published in September in the Journal of Financial Economics. The remaining 96% of companies collectively generated lifetime dollar gains matching those of one-month Treasury bills, the paper stated.

The 90-year sample showed that, "while the overall U.S. stock market has handily outperformed Treasury bills in the long run, most individual common stocks have not," the paper said. In other words, the outperformance of stocks, in aggregate, over bonds was heavily reliant on the few companies that became "home run" stocks — outliers within the samples, according to the paper.

"The results in this paper imply that the returns to active stock selection can be very large, if the investor is either fortunate or skilled enough to select a concentrated portfolio containing stocks that go on to earn extreme positive returns. Of course, the key question of whether an investor can reliably identify in advance such 'home run' stocks, or can identify a manager with the skill to do so, remains," the paper concluded.

For institutional investors with longer-term investment horizons, the issues highlighted in the paper are even more pertinent, Mr. Bessembinder said in an interview in November.

"These issues affect a long-horizon investor more because this phenomenon that I'm describing is more notable over longer-term horizons," he said. "When we compound returns over time, the phenomenon is more recognizable."

Within the context of the active vs. passive debate, Mr. Bessembinder said his research ultimately "adds ammunition on both sides."

"The underlying issue is that, in the long run, only a few stocks are going to drive much of the larger gains," in active investing, he said.

But there is still a case to be made for the right active manager.

"Diversifying broadly ensures that you have those winners in your portfolio — that you don't accidentally miss them. At the same time, my paper shows how big the payoffs can be in identifying undervalued stocks. The potential payoffs for being a successful stock picker are even bigger than we realized," Mr. Bessembinder said.

The research paper does not refute the fact that a diversified stock portfolio will outperform bonds, according to Roger Ibbotson, professor emeritus of finance at Yale University School of Management, and chairman and chief investment officer at Zebra Capital Management LLC, Milford, Conn. But Mr. Ibbotson did find it surprising that the majority of stocks underperformed, while a small minority were left to "carry the day," he said.

Still, "It's not so easy to translate (that) into what to do," Mr. Ibbotson said of the takeaway for investors. "The natural thought would be to go with concentrated managers, but most of your concentrated managers are going to underperform," he said.

For active investors, the research paper tells "a story about risk, and that diversification in portfolios does work," said Eugene Podkaminer, head of research strategies, multiasset solutions, at Franklin Templeton Investments, San Mateo, Calif.

"You spread your bets around because you don't have perfect foresight," into the select stocks that will be the biggest winners, Mr. Podkaminer explained.

Fortunately, many institutional investors already implement this principle into their investing.

"Institutional participants, they have internalized the lesson of diversification probably more so than your average investor has ... And the ecosystems around institutional investors also get it, like the investment consultants," Mr. Podkaminer said.

Separately, there might be an additional buffer in that "most institutional investors have little to no exposure to smaller junk stocks," said Greg Behar, head of index strategy at Legal & General Investment Management America Inc., Chicago. "Quality and liquidity would remove a large portion of those names that fail," Mr. Behar explained, noting the paper looks at the entire market, including penny stocks.

Of the more than 25,000 stocks in the study, 1,088 had a share price below $1 as of the stock's first appearance in the CRSP database, and a total of 6,006 had a share price below $5 as of the first appearance in the database, according to Mr. Bessembinder.

"I think the key is diversification and lower cost transparency, but you have to understand the methodology. Even if you're in a passive index fund or factor-based fund, don't assume that it's diversified and (the manager) is weeding out the lower-quality, illiquid securities," Mr. Behar added.

Keeping Mr. Bessembinder's findings in mind, institutions should take care to hold broadly diversified portfolios that rebalance periodically, understanding there's a place for both active and passive in their portfolios, Sebastien Page, the head of global multiasset for T. Rowe Price Group Inc., Baltimore, wrote in an email.

"The results illustrate the enormous potential, especially over long horizons, for investors skilled enough to identify stocks that will generate compound returns in the far right tail," Mr. Page wrote.