Now, on to more important numbers concerning the management of our portfolios. Financial research, including research examining common stocks and bonds, often relies on numbers to answer a question. Dr. Hendrik Bessembinder does so when he asks the question, “Do Stocks Outperform Treasury Bills?” I find most academic papers on finance and investing of limited use in the day to day practice of building and maintaining a portfolio designed for individuals. This is not to say I gain nothing from the time spent reading them, as any addition to my own body of knowledge is beneficial. But applying the research is for the most part impractical. However, some research does stand out, though this could simply be that the research I find most useful is that which reinforces my own beliefs. Bessembinder’s most recent paper is one such piece that reinforces our approach to portfolio management. Bessembinder also tells us, however, that we are quite silly to expect positive results because the probabilities of success are extremely small.
Bessembinder gives us his answer to the question ‘Do stocks outperform treasury bills?’ immediately in the abstract of his paper:
Most common stocks do not. Slightly more than four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns, inclusive of reinvested dividends, less than those on one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed companies.
In today’s world, it seems that people are jumping wholeheartedly into this approach by buying an index fund and holding on. The largest investors, public pension plans and large endowments, have the time for this, as their timeframe is forever. They are some of the biggest buyers of broad market index funds. However, they have a serious problem, as these plans have a mandatory need for cash flow. By spending the dividends to fund their cash flow needs, they lose the compounding impact of reinvestment that adds substantially to the outcome.
Just as with these large investors, most individuals at some point in their lives need cash flow from their savings. It is normally after retirement when cash is needed the most. Because the real benefits of holding all stocks are derived from reinvesting and time, age and cash flow needs minimize, if not entirely eliminate, the proposed benefits of this approach.
Although the bulk of Bessembinder’s report shows that the record of common stock performance measured one by one is pretty dismal, it does offer hope regarding active stock selection. This hope for those who pursue individual stock selection is saved for the final two sentences of the study. They are worth repeating:
….The results here show that the returns to active stock selection can be very large. If the investor is either fortunate or skilled enough to select stocks that go on to earn extreme positive returns. Of course, the key question of whether an investor can reliably identify such “home run” stocks, or can identify a manager with the skill to do so, remains.
Preservation of wealth does not mean the absence of risk. In fact, it requires a return in excess of price changes (inflation) over time. If cash flow is needed from a portfolio, an approach that has some possibility that the earned rate of return will exceed the cash flow needs, costs, taxes, and inflation is worth pursuing. A difficult, if not impossible task! But by knowing the minimum required rate of return needed to preserve wealth, we can build and maintain a portfolio that increases or reduces risk based on the potential impact to our current state of wealth. A bit more practical than “beating the market.”
The universe of companies that we select from for the inclusion in a portfolio have these characteristics:
- A large market value actively traded on a recognized exchange
- A large amount of revenues
- A low level of debt relative to equity
- Positive cash flow
- Pay a dividend
- A current price less than our estimate of fair value
Granted, total portfolio returns have more to do with actual company selection and portfolio construction, but it doesn’t hurt the process to select from a pool of companies with characteristics that increase our chances of a successful outcome. This is where the findings of Bessembinder’s work are relevant. Of our requirements listed above, his work positively reinforces our own common sense on investing in large financially sound companies traded on a recognized exchange. Here are some of his findings:
On market value: 81.3% of stocks in the largest decile have positive decade buy-and-hold returns, and 70.5% outperformed the one-month Treasury Bill. (The largest decile includes the top 10% of all stocks ranked by market value of equity.) [Table 2A (pg 43) and discussed on pg 15]
On exchange listing: Of those stocks that initially appear on the NYSE, 71.6% had a positive lifetime buy-and-hold return and 65.3% had a lifetime buy-and-hold that exceeded the one-month Treasury Bill return. [pg 17]
On debt: The results on Table 1C indicate that unlevered firms on average deliver strong stock market returns. [Table 1C (pg 42) and discussed on pg 14]
Until next time,
Kendall J. Anderson, CFA
*Bessembinder, Hendrik, Do Stocks Outperform Treasury Bills? (August 22, 2017). Available at SSRN: https://ssrn.com/abstract=2900447