TALK­ING POINT

Ama­zon and Ap­ple ac­count for nearly half of all the S&P’s gains this year

Shares - - CONTENTS -

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)

Source: Bloomberg, Shares

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