The debate

This winter, two British investment managers publicly squabbled.

Lawrence Burns, from investment management firm Baillie Gifford, cited academic research showing that “a small number of superstar companies” accounted for the stock market’s gains. Stated Burns, “The other 99 per cent of companies were a distraction to the task of making money.” For Burns, the results implied an obvious investment strategy: Hold the portfolio’s winners. Profit-taking can be “the worst possible mistake.”

Andrew Dickson, founder of Albert Bridge Capital, strongly disagreed. Three days later, he responded with “Baillie Gifford’s never-sell mantra is a song for fools.” Dickson sharply criticised both the academic paper, which had been presented “in a sensational way,” and Burns’ “after-the-fact diagnosis.” For those who lacked a time machine that would permit them to identify the stock market’s future stars, claimed Dickson, Burns’ advice was “the worst possible.”

Cats and dogs, Madrid and Barcelona, growth and value investors. The language of the Burns-Dickson dispute was new, but not the rivalry. Baillie Gifford buys growth stocks--in recent years scoring big with its Tesla (TSLA) position--while Albert Bridge prefers value stocks. Consequently, Baillie Gifford resists selling equities because they have become costly, while Albert Bridge suggests doing so.

I agree with Baillie Gifford and growth investors on the facts. Last week’s column confirmed the findings of the academic paper. It cannot be denied that, over time, most equities stink. But that information alone does not support the policy of retaining the portfolio’s winners. An additional question must be asked and answered. And when it is, the interpretation favours Albert Bridge/value buyers.

2 market regimes

Consider two hypothetical stock markets: 1) Growth Dream and 2) Value Dream. In Growth Dream, each stock repeats the previous year’s order. The top performer once again leads the way, the salutatorian places second, and so forth. This conduct maximises the compounding effect and thus supports the growth investor’s argument. In Growth Dream, it is always wrong to sell winners.

Value Dream flips Growth Dream on its head by having each stock reverse its previous course. The highest returner becomes the next year’s bottom-feeder; the silver medalist comes next; and the class clown is crowned valedictorian. This conduct minimises the compounding effect and thus supports the value investor’s argument. In the Value Dream, it is always right to sell winners.

My point is that performances compound over time, thereby exacerbating the differences between one stock’s returns and another’s; this must be considered when evaluating whether investors should hold their stock market winners, but the mere existence of compounding does not settle the debate. What matters is how the compounding occurs. If winners tend to persist, as with Growth Dream, let them ride. But if they backtrack, as with Value Dream, harvest their profits.

By the numbers

Happily, this inquiry can be tested. We can examine how stocks actually behave. Below, I compare the percentage of the 1,000 biggest US companies that beat the Morningstar US Stock Index during each calendar year to the percentage of such companies that outgained the index over an entire decade.

Percentage of Outperforming Stocks

The results seemed to support the case for Growth Dream. In a single year, slightly less than half the stocks exceeded the index’s return. Over the decade, one in five managed the feat. That is, while most winners reverted to the mean, a large minority continued to thrive. What’s more, 4 per cent of companies more than tripled the cumulative gain of the index. Surely that level of success demonstrated genuine persistence. It couldn’t have simply been luck.

Then I thought again. If a coin is flipped 10 times, the most likely result is five heads and five tails. However, that is scarcely the only possible result. In fact, achieving an equal number of heads and tails with 10 flips occurs on only 25 per cent of occasions. With many other sequences, either heads or tails predominate, which might lead naïve observers to perceive a pattern that does not exist.

In other words, chance alone will create stock market outliers. If there were no true persistence, such that equity returns were purely random, some stocks would nevertheless enjoy unusually high compounded gains. Consequently, that the amount of stock market winners shrinks over time is beside the point. The critical question is: Is this percentage more or less than would occur by chance?

With enough effort, I could probably have resolved this query through equations. But with modern computing power, there was no need. I simulated. By drawing randomly from the 2011 returns, 2012 returns, 2013 returns, and so forth for each of the 1,000 companies, I constructed an artificial 10-year stock history. This security never existed, but it could have, because it was created from the same material--that is, the same 10 calendar years of 1,000 individual stock returns--as reality.

I repeated the process several thousand times to generate 5,000 artificial 10-year performances and then compared the distribution of the clone stocks’ annualised returns to those of the actual marketplace.

Actual Market vs Simulations

Bingo! Across the board, the simulations mirrored the real world. This result shouldn’t be interpreted to mean that the market’s top performers became that way because such companies were fortunate. Such a conclusion would ask too much of the evidence.

What we can say, at least over the previous decade, is that the distribution of US stock returns--that is, the manner in which they compounded--is indistinguishable from what would have been achieved by chance.

Which means that, absent the gift of foresight, there’s no reason for stock investors to hold their winners. Yes, some of those securities will continue to thrive, thereby enjoying the virtuous circle of higher returns compounding previously high returns. However, if investors chose instead not to retain their winners, instead shifting those assets into randomly selected securities--as done through the simulations--they would have fared equally well.

If stock performances showed higher persistence than would occur through chance, then the odds would favour investors who follow Baillie Gifford’s advice to keep those that got you here. But they do not.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.