The received wisdom is that, for any investment, it is good to protect the downside. If a stock loses 50%, it needs to gain 100% to get back to its original level. But could it be more expensive to miss the winners than hold a few losers in a portfolio?
The long-standing emphasis on the importance of protecting the downside has been rigorously challenged by the team on the four-star rated Baillie Gifford American fund. It cites research from Hendrik Bessembinder, professor at Arizona State University’s W. P. Carey School of Business, showing that stock market returns are concentrated in a few high growth companies. Miss them and you might as just have your cash in the bank.
At the core of Bessembinder’s research is the fact that the greatest returns come from very few stocks overall. In fact, just 86 stocks have accounted for $16 trillion in wealth creation – half of the stock market total – over the past 90 years. And all of the wealth creation can be attributed to the 1,000 top-performing stocks over the period.
96% of Stocks Don't Matter
Meanwhile, the returns generated by the remaining 96% of stocks collectively matched one-month US Treasury bills. What that means is simply 25,000 of the 26,000 companies surveyed did not matter for long-term equity returns.
By this logic, it is far more important to find those handful of stock responsible for vast wealth creation, than to focus on not losing money in the others. Helen Xiong, manager of the Baillie Gifford American fund, points out that while potential downside on any single holding is 100%, the upside is uncapped.
Xiong puts this in portfolio terms by comparing Lending Club, a holding added to the portfolio in 2015, which subsequently lost nearly 70% of the initial investment and Netflix, which it has held since 2016. She first looked at Netflix in 2011 and decided against buying the stock. By the time the team bought it in 2016, the shares had already gone up seven-fold – had they invested in 2011, they would already have made a return of 700%.
She asks: which was the bigger mistake? “Not buying Netflix at the end of 2011 was seven times costlier in performance terms than buying Lending Club and getting that wrong.”
This is a compelling argument for a certain approach to growth investing. The problem, says Xiong, is that investors aren’t good at understanding exponential growth - that 2x2x2 = 8. This means that they tend to underestimate the growth potential of great companies - Amazon, Netflix, Alphabet, to name just a few.
However, Gary Potter, joint head of multi-manager at BMO Global Asset Management, says this can a difficult message for investors to grapple because, inevitably, this approach may bring more volatility than one focused on protecting the downside potential: “Significant drawdowns have an implication for long-term capital and individual clients staying in the market. If a client loses 40% or more in a market correction, the chances of them still being in the market three to five years later are slim.”
Growth Stocks are Expensive
That argument is important today because growth stocks look more highly valued than they have for some time. Graham Campbell, joint manager of the two-star rated TB Saracen Global Income and Growth fund, says the portfolio currently has the strongest “value” tilt in its history because this sort of high quality growth businesses are “the most expensive they have ever been”.
Potter is clear that investors have made vastly far more money by finding winners than backing average companies at cheaper prices over the past decade, but says it has been an environment in which such “winners” have been highly prized. This support for high growth companies has a number of drivers: quantitative easing and low interest rates have been an important element, reducing the risk-free rate and driving up the value of future cash flows for high growth companies.
At the same time, we are living through a period of unique disruption. The retail sector, motor industry, and financial services are all undergoing profound change and the spoils for those on the right side of those developments are vast. At the same time, companies are becoming obsolete more quickly if the changes go against them; “creative destruction” is increasingly destructive. However, there is an unfashionable argument that disruption is not permanent and super-normal returns may not always be available.
The uncomfortable conclusion is that while finding the winners is almost certainly a better approach, investor sentiment needs to adapt. Potter points out that since the financial crisis, investors have become so focused on avoiding risk at all costs, that they are unwilling to look three to five years ahead.
Growth companies are at a sensitive point after a strong run of performance. For Baillie Gifford, who are looking to the long-term, this isn’t a problem - Amazon shares looked expensive back in 2000 and yet are now 20 times higher. However, trigger-happy investors, prone to selling out when it starts to feel difficult, need to stay invested to reap the benefits.
