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\40% Of All Stocks Have Experienced Catastrophic Declines

By Rupert Hargreaves. Originally published at ValueWalk.

Diversification vs concentrated stock investing

Concentrated investing is not advised by most wealth managers but it is advised and practiced by the majority of the world’s most successful investors.

This conflicting advice presents a dilemma for those investors looking for guidance on the topic. On the one hand, there’s a wealth of information which supports the conclusion diversification is the only way to ensure steady portfolio returns without the risk of being wiped out overnight. But on the hand, this academic research looks misleading when compared to the multi-billion-dollar fortunes built by the likes of Warren Buffett and Charlie Munger thanks to their concentrated strategy.

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Diversification  vs concentrated stock investing

‘The Agony And The Ecstasy: The Risks And Rewards Of A Concentrated Stock Position’ is the title of a special edition of JP Morgan’s regular ‘Eye On The Market’ publication published this month. Within the issue, Michael Cembalest, Chairman of Market and Investment Strategy at J.P. Morgan Asset Management, discuss the topic of concentration, from the Ecstasy of creating wealth to the Agony of how concentration can destroy wealth and result in permanent capital impairment.

The main theme running through the publication is that while some superstar investors have managed to make a fortune by using a concentrated strategy, the odds have been stacked against the average concentrated holder. Using data from the S&P 500 index since 1957, JP Morgan’s analysts find that there has been a “steady drumbeat of creative destruction” in the market over the past three decades. A compiled, detailed history of additions and deletions from the index since 1980 shows an alarmingly high turnover rate even after adjusting for companies that were removed from the index because they were acquired, merged or re-incorporated outside the US. There have been 320 companies deleted from the index since 1980 due to substantial declines in their market value or outright failure.

Looking at companies outside the S&P 500, in the Russell 3000 JP Morgan’s analysts find that around 40% of all stocks experienced catastrophic declines since 1980 when defined as a 70% decline from peak value with minimal recovery. These are large permanent declines, not just temporary declines during the tech boom-bust or the financial crisis. These figures have been flattered to some degree by the Federal Reserve monetary experiment that has been ongoing since the financial crisis. As shown in the chart below, as the real cost of money has been negative for more than five years, the percentage of companies suffering a catastrophic unrecovered loss of 70% or more has collapsed from an average of around 10% per annum to under 3%. It can be assumed that when monetary policy normalizes, catastrophic loss rates will recover to the historic median.

diversification

Focusing only on the risk of failure misses half of the picture: the potential rewards of a concentrated stock position.

One way to assess the risks and rewards involved is to look at all stocks and compute their respective “lifetime” price returns versus the Russell 3000. Once again the figures are disappointing. JP Morgan’s analysis shows the median stock underperformed the market with an excess lifetime return of -54%. What’s more, two-thirds of all excess returns versus the Russell 3000 were negative, and for 40% of all stocks, returns were negative in absolute terms. Even stripping out bubble companies such as 1995/2008 Tech, Biotech and Finance has a similar impact on the results. When excluding these companies, the median return is still negative, the percentage of companies underperforming the index is still around two-thirds.

Still, there were some winners during the period. Around 7% of the universe between 1980 and 2014 produced extreme returns of 500% or more.

diversification

Considering these disappointing performance figures, it’s no surprise JP Morgan’s Michael Cembalest can quickly draw the conclusion that barring some outliers, for most investors diversification is the best course of action:

“The frequency of catastrophic declines and the negative skew in the distribution of individual stock returns compound our perception of concentrated stock risk, and suggest that diversification play an important role in wealth planning for most entrepreneurs.”

The report also has a section specifically devoted to the GSEs – Fannie Mae and Freddie Mac.

The report states:

 US government-sponsored enterprises took a lot of the oxygen out of the room: the green and red lines in the chart show the increase in high-risk lending undertaken by the GSEs which predated the massive increase in subprime and Alt A lending by the private sector (black line). The GSE increases move roughly in tandem with lending standards which required the GSEs to make more low and moderate income loans (blue line). This timeline is not meant to absolve the private sector, which made some horrendous and well-documented underwriting decisions; the point is to understand what government actions and policies preceded them.

JPMorgan notes that while the GSEs were supposed to have high lending standards this did not last.

In 2003, the private sector found a way to compete: the deepening of private mortgage backed securities markets. Home prices surged further, and the mortgage market doubled in size vs. 2002. The private sector regained market share, mostly through subprime and Alt A loans which rose to 40% of annual origination. To be clear, private sector defaults and losses per dollar on subprime were much worse than on GSE loans, particularly when related to malignant derivative offshoots.

The post \40% Of All Stocks Have Experienced Catastrophic Declines appeared first on ValueWalk.

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