Amazon and Apple account for nearly half of all the S&P’s gains this year
How a handful of stocks can drive the entire market
In mathematics, ‘skew’ means a slant or an oblique angle. In everyday use, skew means some type of bias or tendency away from normal distribution.
Many of us should be familiar with the 80/20 rule which says that 80% of your results come from 20% of your effort.
Business coaches claim that 80% of sales come from 20% of customers. And most of us probably spend 80% or more of our time watching fewer than 20% of the available channels on television.
This is all relevant to investing, as we now explain.
THE VITAL FEW VERSUS THE TRIVIAL MANY
Italian economist Vilfredo Pareto came up with the idea in the late 1800s while studying Italian wealth and society.
His theory, known as the ‘Pareto Principle’, was that 80% of the nation’s wealth was controlled by 20% of the population or ‘the vital few’ as he called them.
The remaining 20% was spread among 80% of the population, called ‘the trivial many’.
If the skew in Italian wealth in the 1890s seems high, the skew in financial markets between the ‘vital few’ stocks in a portfolio or an index which deliver most of the gains and the ‘trivial many’ can be even greater.
A recent research paper by Hendrik Bessembinder of W.P. Carey School of Business suggests that almost all of the out-performance of stocks over bonds in the US over the last century is accounted for by less than 5% of stocks.
So while the average stock has beaten the bond market, in reality all of that excess return has been generated by a very small number of stocks.
This is counter to most people’s expectations and to the normal distribution of returns.
GOING ‘OUT THE CURVE’ IN SEARCH OF RETURNS
The accompanying chart is called a ‘bell curve’ because of its shape. It shows what the normal distributions of returns should be if the stock market is ‘efficient’ (i.e. all available news is priced in).
The top of the bell is the index average, or mean, and either side are dotted standard deviation bands.
It stands to reason that the average stock will produce an average return, or one in line with the index, and most stocks (68%) will produce a return within one standard deviation of the average.
Bessembinder’s study suggests that all of the excess returns from investing in stocks have come from the extreme right-hand side of the curve (between the second and third deviation bands) or less than 5% of stocks.
This means that any fund manager wanting to beat the index has to own this tiny group of stocks, assuming they can identify them in advance.
FOCUSED FUNDS MAY BE MISSING THE POINT
This research may be new but the concept of only investing in a small number of stocks in order to capture excess returns is far from new.
There is any number of ‘focused’ or ‘growth’ funds, typically with fewer than 50 stocks, which claim to capitalise on their manager’s superior stock-picking ability to beat the market.
However what quickly becomes apparent is that a great many of these funds own the same stocks, often in the same proportions. It could be that the managers all use the same investment approach, or they could all use different approaches, but they still end up with the same stocks.
Either way, if one gets it right they all get it right, but if they’re all wrong they are all on the hook.
This is the downside of skew, which investors experienced recently with the sharp sell-off in technology stocks.
US RETURNS ARE THE MOST HEAVILY SKEWED
You only have to look at the top five stocks in the US in terms of contribution to the rise in S&P 500 to see the scale of the skew towards the technology sector (see table).
What this reveals is that if a fund manager didn’t have at least the same weighting as the index in just three out of 500 stocks – Amazon, Apple and Microsoft – they would have missed out on almost two thirds of the index’s gains this year.
The skew in the UK is less notable, but even so if you didn’t have at least a market weighting in the big pharmaceutical stocks AstraZeneca (AZN) and GlaxoSmithKline (GSK), and the big oil stocks BP (BP.) and Royal Dutch Shell (RDSB), you would have struggled to beat the FTSE 100.
As always an element of luck helps, and owning three FTSE 100 stocks in takeover situations this year – GKN, Shire (SHP) and SKY (SKY) – wouldn’t have done any harm, but they still wouldn’t have made up for the returns lost by being underweight the large oil and pharmaceutical stocks.
SKEW AT STOCK LEVEL COULD REFLECT SKEW IN CAPITAL RETURNS
One of the arguments put forward for the skew in returns in the US is that there is a large skew in returns on capital.
Technology has given firms such as Amazon, Apple, Google and Microsoft a huge advantage.
In the past there would be a ‘trickle-down’ effect as technology and know-how spread through the economy to other companies.
This is no longer happening because companies are keeping their technology to themselves in order to eventually create dominant market positions where all the profits accrue to them.
Identifying this trend and investing in these companies has generated fabulous returns, but as the recent sell-off has shown, they aren’t immune. (IC)