1. Extreme Returns

    By James Anderson. Autumn 2018
    Illustrations by Craig Frazier.
  2. James Anderson, joint manager of Scottish Mortgage Investment Trust, talks about the implications of Hendrik Bessembinder’s extraordinary research

      

    This article originally featured in Baillie Gifford’s Autumn 2018 issue of Trust magazine.

  3. Generally I prefer our research to appear irrelevant. The further it is from being a direct debate about the merits of a company as an investment the happier I tend to be. Obliquity is superior to confrontation. Walking is preferable to staring at a computer screen. Much of the most valuable research is deeply indirect in its investment implications and surprising in its eventual impact. Most commentators, brokers, intermediaries and consultants are deeply offended by such musings. That’s their problem.

    But occasionally direct assault has its virtues. This particularly applies to academic input. It can have the ability to stand outside the moment. It certainly has the ability to free itself from the preconceptions, self-interest and necessary operating dogma of practitioners and industry insiders. The very absence of skin in the game can be a virtue. Radical reappraisal is possible. Sometimes external authority gives the necessary evidence and context to build on uncomfortable and unexpected rumblings of our own.

    Such has been our experience of working with Hendrik Bessembinder of Arizona State University. In early 2017 Professor Bessembinder released his initial drafts of a paper entitled Do Stocks Outperform Treasury Bills?. The title itself is heretical. It is a central assumption of Modern Portfolio Theory as taught to all students that because equities are more risky they must have higher rewards. This is drummed into the heads of the record 227,031 candidates who registered for the Chartered Financial Analyst (CFA) exams in June. But Bessembinder showed that “slightly more than four out of every seven common stocks have lifetime buy-and-hold returns, inclusive of reinvested dividends, of less than those on one-month Treasuries.

    “When stated in terms of lifetime dollar wealth creation, the entire gain in the US stock market since 1926 is attributable to the best-performing 4 per cent of listed companies.” As he put it to me this is “just a collection of facts”. It’s not fake news. If this was the character of the US market in the past how much more might it be the path in the global and digital future?

     

     

    …the entire gain in the US stock market since 1926 is attributable to the best-performing 4 per cent of listed companies.

    Professor Hendrik Bessembinder

     

    But if this is right then our task is transformed. Our job is solely and simply to find and invest in the stocks that are capable of producing the extraordinary returns of the 4 per cent. Everything else is best put aside. But what characteristics might the companies need to produce these returns? What attributes in turn do we need to hope to identify them? As Bessembinder writes, “The returns to active stock selection can be very large. If the investor is either fortunate or skilled enough…” So the natural course of affairs was for us to build a relationship with the Professor so that we could learn how to become skilled (or lucky). Fortunately my colleagues are now expert in providing sufficient freedom and support, both financial and intellectual, that we can progress towards regular contact in such instances. So in March I found myself sweltering in Tempe rather than freezing in Edinburgh in order to discuss these matters. Tom Slater, joint manager of Scottish Mortgage Investment Trust, had preceded me. Although we both found that Professor Bessembinder veered to academic caution rather than fund manager exuberance there was still a great deal of importance to digest.

  4. The two main areas of research that we have agreed to work with the Professor on at this early stage are focussed on expanding data to the rest of the world (we are helping with the limited data sources) and trying to find common factors behind both the 4 per cent of the companies that have created all the return and the even more remarkable 90 companies (out of over 24,000) that have contributed half the wealth created in US equities since 1926. It’s this second question – in both versions – that has begun to unearth potentially crucial insight. It looks as if there could indeed be common factors behind the brilliance. Although many stocks with the most stellar returns now appear ex-growth (Exxon Mobil) or once mortally wounded but now surgically reassembled (General Motors), at the start of their lives they were all participants in markets that would become very large and that they entered if frequently not first then at early stages (this has been the case from Exxon Mobil to Google). As these names indicate titanic founder-owners or at least missionary leaders are the enduring pattern.

    An assemblage of FTSE 100 style companies boasting chief executives with three-year tenure does not feature. Moreover these companies have not been run with slide rules or their ancient and modern equivalents. They are companies that acknowledge doubt and embrace emerging opportunities. As Hendrik Bessembinder was talking about this my mind went automatically to Jeff Bezos 20 years ago enthusing about the ‘weirdness’ of how the inputs to his business got better and cheaper every year – but that even he had not a clue of what that would mean.

    Now in a sense much of this is predictable even if it’s more acute and structural than we surmised. What is more striking and even more exciting is the attributes that the Professor believes that investors in their turn need to possess in order to identify the truly great potential companies. Just like the company founders themselves he thinks the skills we need are centred on dreaming of a grand future, backing great people and coping with twists and turns and ups and downs.

    His explication seems to us to run very counter to the perceived market wisdom. It certainly casts doubt over the strong preferences of most investors for predictability and certainty. But still more his perceptions indicate that our job is much more about the imagination of the future that can envisage brave new worlds and the qualitative assessment of leadership skills than about the hard analytic numbers and confident financial mastery that the 227,031 are being examined on by the CFA. So to us the hope – or inspiration – that Professor Bessembinder provides is that as our financial industry marches firmly and unanimously up one hill that we’re running determinedly in the opposite direction. If we are right that is a compelling competitive advantage.

    But there’s one last essential to the Professor’s current thinking. Identifying the great investments isn’t enough. As Hendrik Bessembinder makes plain it is the long-term compounding of their share prices that matters. This seems to us to require an additional set of skills such as the creativity to imagine greatness discussed above. The compelling urge amongst ordinary humans for sure, but far more damagingly amongst that odd sub-breed that are fund managers, is to take profits and lock in performance. As the old saying goes: ‘it’s never wrong to take a profit’. But it is often not just wrong but the worst mistake that can be made. So I first wrote a note asking if Amazon had gone up too much at $77. Thankfully the conclusion was that there might be more to go for at that juncture. We’re still resisting the temptation around $1,700. Professor Bessembinder is reinforcing such convictions.

     

     

    2014

    2015

    2016

    2017

    2018

    S&P 500 annual past performance to 30 June each year (%)

    24.6

    7.4

    4.0

    17.9

    14.4

     

    Source: S&P. Share price, total return in US dollars.
    Past performance is not a guide to future returns.

     

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  6. James Anderson

    James Anderson has managed Scottish Mortgage Investment Trust since 2000. James is a partner at Baillie Gifford and was a member of the Advisory Board of the Kay Review.