[00:02:30] Clay Finck: Well, in all honesty, I kind of stumbled into this line of research by accident.

[00:02:36] Clay Finck: And the answer of how it happened is actually a little bit techy, but I was, I’m basically a data guy, a statistics guy, a finance professor who studies the markets. And I was working on a project with a couple of co authors and we were studying stock price performance after events like IPOs and secondary offerings and the like.

[00:02:54] Clay Finck: We had a pretty big sample of stocks, and for some technical reasons, we had decided in that study to look at continuously compounded returns, or logarithmic returns. And I was looking at our data, our summary statistics, for a pretty big sample of stocks, and I noticed that the average continuously compounded return for this pretty big sample of stocks was a negative number.

[00:03:17] Clay Finck: I was surprised. I wasn’t expecting to see a negative average return for a big sample of stocks. And just another techie aspect here, I had in mind that one of the reasons people study logarithmic returns is, is that they add up nicely. So if an average is negative, then the sum of all of them is negative.

[00:03:36] Clay Finck: And a logarithmic return is not actually a return. You have to convert it back, but you don’t change the sign when you convert it back. But I’m just looking at this data, and it suddenly occurs to me, a lot of these stocks are losing money in the long run. And I wasn’t expecting that. So I thought, well, I should really start digging into this a little more systematically.

[00:03:56] Clay Finck: So I did start digging in systematically, and that led to the paper you mentioned. I should mention, by the way, I titled that paper, Do Stocks Outperform Treasury Bills? I mean, that was basically the strategic title. My thinking is if you use that title, people have to look, they have to see what’s this guy talking about.

[00:04:15] Clay Finck: But underlying the outcome, so that the outcome that’s in the outcomes in that paper is skewness. And that’s another kind of techie term, and maybe you prefer asymmetry. But the fact is stock market returns, once we’ve compounded them for a while, are positively skewed. If you have positive skewness. It means the average outcome is higher than most of the individual outcomes.

[00:04:40] Clay Finck: And that’s essentially what’s going on, essentially what drives this, this whole line of research. If I had labeled that original paper, stock returns are skewed, I just don’t think it would have caught people’s attention in the same way that the actual title did. Anyway, so it is really something that I kind of stumbled into, but once I stumbled into it, I thought, wow, these results are really striking.

[00:05:00] Clay Finck: I should circulate them. Went ahead and did that, and it’s been interesting to see how much attention has been focused on it since then.

[00:05:08] Clay Finck: One of your comments that stuck out to me At the start of your answer was that the average return for a stock is negative and that surprised you for those that might not be math inclined.

[00:05:19] Clay Finck: Why did that finding surprise you?

[00:05:22] Hendrik Bessembinder: Well, there’s a big economic body of theory and evidence about risk return trade offs. And stocks are one of the more risky asset classes. Maybe not the very riskiest, maybe venture capital is more risky. Maybe some exotic markets like say electricity derivatives might be more risky, but stocks are among the riskier assets.

[00:05:42] Hendrik Bessembinder: So we expect a positive average return in stocks. And I should clarify, it is true that the average return, the mean, the same average you’ve been talking about since sixth grade or so, the mean return on stocks is positive. It’s that return on a typical stock is not positive. So that’s one of the striking things that came out in my original study.

[00:06:04] Hendrik Bessembinder: I used a database, acronym is CRSP, Center for Research and Security Prices is put together by the University of Chicago. It’s what most academics study and it’s kind of considered the gold standard database for reliable historical stock return data. I studied this CRSP data since 1926, all the individual stocks, found that the majority of stocks lose money.

[00:06:27] Hendrik Bessembinder: I focused in the paper on comparing stocks to treasury bills. Because I had in kind of in mind the idea of a risk premium, we’re supposed to earn a risk premium in stocks as compared to something low risk like treasury bills. Anyway, what I found is that the majority of stocks, about 4 out of 7, don’t beat treasury bills in terms of their compound returns.

[00:06:47] Hendrik Bessembinder: If I focused on a number that I called shareholder wealth creation, which the biggest difference between that and a compound return is it just takes the size of the investment into account. So if we want to ask a question like, well, investors, the body of investors, the group of investors in the stock market, how have they done in the long run?

[00:07:06] Hendrik Bessembinder: How much wealthier have they become? With that sort of question, it’s natural to think about things in dollar terms, which then puts more importance on big stocks. In any event, when I did look at things in dollar terms in this wealth creation measure, it was even more striking. About 4 percent of the stocks accounted for all of the net wealth creation in the stock market since the U. S. stock market since 1926. So I was surprised because we usually think there’s a positive risk return trade off and I should mention it is there on average but it’s not there for the typical stock. How can it be there in the average even while it’s not there for most stocks? Because there’s a few stocks that do tremendously well that pull up the average.

[00:07:52] Hendrik Bessembinder: That’s the essence of the findings.

[00:07:55] Clay Finck: Yeah, and if I can paint some numbers from your research, I believe one of the earlier studies that looked at 25, 000 companies in aggregate, they created 35 trillion in net wealth creation. But if we tune into those top, top performers, the top 90. I count for over half of that 35 trillion and it’s the top 1092 that is the 4 percent figure you’ve referenced there that accounted for that in aggregate 35 trillion.

[00:08:25] Clay Finck: So I think that top 90 really stands out to me. So it’s just like this tiny subset is driving so much of the performance of the broad overall market.

[00:08:35] Hendrik Bessembinder: So those were among the results that surprised me and I think surprised a lot of people. I should mention when I first came across these results, I was starting to talk to some of my academic colleagues about it.

[00:08:46] Hendrik Bessembinder: Many people like me were surprised, but there was a handful of them who said, well, of course, what did you expect? Which just shows that some people had already thought carefully through these issues, even if they hadn’t stopped to actually document it previously.

[00:08:59] Clay Finck: And you mentioned venture capital, people often think that a venture capitalist is going to go out, they’ll make a hundred investments, and they’re very happy if one or two or three work out very well, and people sort of perceive that as a risky activity, venture capital in general, but they’re doing the same thing when they buy a passive index fund.

[00:09:18] Clay Finck: Those just a select few is going to be driving those returns. So skewness is something that we see in many areas of investing life, a lot of areas. And people talk a lot about power laws and it relates to that as well.

[00:09:31] Hendrik Bessembinder: Yes, agreed. So I think skewness is pervasive. One of the ways I’ve described the results of this study is I said, I said, look, I’m going to tell you about an asset class.

[00:09:41] Hendrik Bessembinder: And in this asset class. Most of the investments lose money. As a matter of fact, the single most common outcome is losing all your money, but there’s a few really big winners. There’s a few of these investments that really pay off handsomely enough to make this asset class worthwhile and desirable. And if I described it that way, a lot of people would respond.

[00:10:03] Hendrik Bessembinder: Yeah, we know that about venture capital, but of course I’m talking about publicly traded common stocks over longer horizons. So what I conclude from this is that this positive skewness, it’s not something that just shows up in some corners of the capital markets, like venture capital. It’s really pervasive.

[00:10:21] Hendrik Bessembinder: It’s fundamental to investing in an entrepreneurial economy.

[00:10:26] Clay Finck: So if you were to try and explain why this skewness exists to such a large degree that so few companies generate the majority of the wealth and the economy and the majority of the returns for investors, how would you try and explain why that is?

[00:10:42] Hendrik Bessembinder: Well, there’s a couple of ways to come at it. One of them is just kind of, let’s think about the details of what happens when your compound returns. The other is just kind of think about things at a big picture, intuitive level. Let’s take the first of those first, just what happens when you compound returns.

[00:10:58] Hendrik Bessembinder: Real simple numerical example. Suppose returns are either 10 percent or negative 10%. Nice round numbers, nice symmetric, nice symmetry there. Suppose you draw, you get lucky and you draw 10 percent returns two times in a row. 10% compounded for two years is not 20%, it’s 21%. On the other hand, you might get unlucky, you might draw negative 10% two times in a row.

[00:11:22] Hendrik Bessembinder: But negative 10% compounded for two years is not negative 20%. It’s not negative 21%, it’s negative 19%. Alright? Simple example. But you can already see the asymmetry. Two good draws in a row. You’re up 21%, two bad draws in a row, you’re down 19%. That’s essentially it. You can have complete symmetry in what happens in the short run.

[00:11:44] Hendrik Bessembinder: But once you compound things out, you get asymmetry. The longer you let that run, the bigger the asymmetries get. The bigger the degree to which the upside is bigger than the downside. So it comes right out of the mechanics of compounding. But if we backed away from that example, just thought about things kind of intuitively, and you know, what do we actually see in the markets?

[00:12:05] Hendrik Bessembinder: Well, what’s the worst you can do on a stock? Negative 100%. Okay, that’s mad. And it does happen surprisingly often that was one of the things that came out of my study, but you’re capped on the downside at negative 100%. It’s because of limited liability, but you’re not capped on the upside. And many, many stocks do more than a hundred percent.

[00:12:25] Hendrik Bessembinder: And as I’ve shown in the series of studies, but not totally a surprise, many people have taken note of this in the past and the upside of stock can generate thousands of percent, tens of thousands of percent, or in a few cases, a million percent. So the limited liability unlimited upside is just another way of seeing that things are asymmetric in the long run in the investment world.

[00:12:47] Clay Finck: So another interesting finding, I think, is looking at the performance of stocks overall relative to treasuries. And consistently, this is just a pretty wide margin between the performance of these two asset classes. Why do you think there’s this almost continuous performance of stocks over an asset class like treasuries?

[00:13:10] Hendrik Bessembinder: To go back to kind of basic economics, we believe people are risk averse. They need to be induced or compensated to get them to take risky investments. At least that’s kind of a pillar of economic theory. Though it is interesting that you can find counterexamples out there in the world. I mean, Las Vegas and casinos in general provide a counterexample.

[00:13:28] Hendrik Bessembinder: There may be a couple of games of chance where you can tip the odds in your favor, but, you know, they’re likely to show you the door if they find you card counting. But those are some counterexamples that are worth thinking about, but in any event from an economic theory perspective, we believe that there should be inducement to get people into this risky asset class stocks when you could be in low risk alternatives.

[00:13:49] Hendrik Bessembinder: From an academic perspective, in terms of what’s been written in the economics literature, there’s a phrase equity premium puzzle, and that phrase is basically, it’s surprising how well stocks do, how big the premium is for the overall stock market. It depends on exactly how you measure it and exactly what period of time, of course, but numbers like 8 percent per year are thrown around as the equity premium.

[00:14:13] Hendrik Bessembinder: And by some measures, that’s a surprisingly large outcome. I might mention though, I think you use some phrasing along the lines of you know, reliable premium or most of the time premium or something like that. There is ongoing debate about how sure can we be that stocks will outperform low risk alternatives in the long run.

[00:14:32] Hendrik Bessembinder: And there was a recent paper in the Financial Analyst’s Journal by a fellow named Deb McGuire, I believe he brought out some additional historical data and says the odds that overall stock market might underperform over, say, a 20 year horizon are a little higher than than what some people have argued.

[00:14:48] Hendrik Bessembinder: The historical data shows the overall stock market has outperformed treasuries by very handsome margins in the long run, which I think only makes it a little more striking that so many individual stocks don’t do so.

[00:15:02] Clay Finck: So one might look at a study like yours and simply say that they’re just going to go out and try and buy the winners, but if only the stock market were so easy.

[00:15:12] Clay Finck: The biggest winners also tend to have gut wrenching drawdowns. Just to pull one example from one of your studies, you found that Apple, it created more shareholder wealth out of any company from 1981 through 2019, but it also experienced three drawdowns of 70 percent or more. Talk more about some of your findings from this study on drawdowns and what might be a normal drawdown for a high performing company.

[00:15:41] Hendrik Bessembinder: Yeah, I mean, there’s no way to say with any degree of certainty what’s going to happen in the future, but I’ve studied pretty big databases of what’s happened in the past, and that’s something we should pay attention to. So, in the study you just alluded to, what, what I did is I looked at things at the decade horizon.

[00:15:57] Hendrik Bessembinder: And I basically asked, let’s focus on the stocks that turned out to be big winners in a given decade. I focused on the top 100 stocks in terms of enhancing shareholder wealth by a decade. And then I just asked, well, what sort of drawdowns did we see? These are stocks that turned out doing really well.

[00:16:14] Hendrik Bessembinder: How did they do? You mentioned Apple as a striking example of a stock that had some gut wrenching drawdowns. Amazon, not three times, but they have a 90 percent drawdown. In any event, what I found is in the study of things at a decade horizon, even within the same decade where the stocks turned out to be big winners, they had drawdowns that averaged 33%.

[00:16:36] Hendrik Bessembinder: And in the prior decade, the decade before they went on to become big winners, they had drawdowns that averaged 52%. So I know among your viewers, there’s quite a few people who try to engage in stock selection. Just recognize that drawdowns happen frequent. Even for the big winners, it’s not unusual to see big drawdowns, so just take into account that that’s part of the game.

[00:16:57] Clay Finck: And when looking at the industry breakdown, many of these top performers are often technology companies, especially nowadays. And that can just make things even more complex for stock pickers. These types of companies seem to be more difficult to understand, faster changing industries, a lot of potential for disruption that is almost impossible to foresee for many people.

[00:17:20] Clay Finck: And for every tech winner, there tends to be a long list of companies we’ve never heard of that produced deeply negative returns. To what extent do technology companies dominate this list of top performers?

[00:17:33] Hendrik Bessembinder: Yeah, it’s a good question. When you look at one of the lists I created of the top performers in dollar terms, there’s a lot of tech companies on that list.

[00:17:43] Hendrik Bessembinder: But as you said, nobody forgets Apple. Nobody forgets Microsoft. Nobody forgets NVIDIA. What’s easier to forget is the dozens of tech stocks that were around for a while and it failed. So when I dug deeper into it, I actually found that technology stocks were not more likely to end up at the top. As a matter of fact, to a slight extent, tech stocks were more likely to end up among the bottom performers than to end up among the top performers.

[00:18:09] Hendrik Bessembinder: And I actually found that a couple of other industries in particular, healthcare and pharmaceuticals, as well as energy firms, somewhat more likely to end up in the top performing list as compared to their percentage of all the stocks. This wasn’t a night and day thing. It’s not like, you know, any industry is going to reliably provide the stocks that end up at the top performing list.

[00:18:30] Hendrik Bessembinder: But tech stocks were not the most likely, and by a small margin, health and pharmaceutical stocks and energy stocks were actually more likely to end up near the top of the list.

[00:18:40] Clay Finck: And the most popular study looked at the performance of individual stocks relative to treasury bills. And we find that around 4 percent of stocks generate all of the net wealth creation.

[00:18:52] Clay Finck: And I believe just under half, around 42 percent outperformed one month treasuries. Have you looked at any data that instead of comparing to the performance of treasuries, you’re looking at some sort of market index, like say the Dow Jones Industrial Average or S&P 500?

[00:19:10] Hendrik Bessembinder: I’ve never actually compared to those widely recognized indices.

[00:19:15] Hendrik Bessembinder: And that’s in part because the indices themselves have their peculiarities. You’re probably familiar that the Dow is, is a something of an odd creature, a price weighted index. The S&P 500 is more straightforward in being evaluated index of the biggest stocks, but there’s still some discretion. In terms of which stocks get included in that index of which don’t, it’s not purely the highest market capitalization stocks, so I went with something just a little more agnostic is that I just computed a value weighted portfolio of all the stocks listed on the markets, all the stocks included in the CRSP database.

[00:19:52] Hendrik Bessembinder: So it’s not an index. It’s just a per valuated portfolio of all the stocks. I did several of my studies. I also compared to the valuated portfolio. The effects of skewness are still evident there. The majority of stocks underperform the valuated portfolio. You know, if it was a purely symmetric distribution, the average stock would match the average return.

[00:20:12] Hendrik Bessembinder: But even there, you see at most stocks underperform their own valuated average, just another way skewness presents itself.

[00:20:20] Clay Finck: I know this might be the million dollar question a lot of listeners are waiting for. What are some of the characteristics that might help us select, say, a big winner? What are some of the things that are attributed, or what characteristics are found in some of these big winners?

[00:20:36] Hendrik Bessembinder: Yeah, so this is what everybody wants to know. And of course, they don’t want to know just what are the characteristics that you can observe after the fact. They want to know what predicts. And we don’t have to turn this into a long treaty on market efficiency. The markets are not perfectly efficient.

[00:20:53] Hendrik Bessembinder: There’s a lot of debate about, you know, well, are they close? Are they not close? And, you know, I don’t have any final answer to that question. There’s a big ongoing debate about how efficient the markets are. I don’t know if they’re efficient, but what I do know is it’s competitive out there. There’s a lot of smart people looking for the answer to the question you posed.

[00:21:11] Hendrik Bessembinder: So nothing’s going to be easy. If I had told you I did a study and I found this variable that you could find on the firm’s accounting statements and it reliably predicts who’s going to be the big winner next year, if that’s what I was saying, you should be highly suspicious of that. So anyway, that’s not what I’m going to say.

[00:21:27] Hendrik Bessembinder: It’s devilishly hard to predict who’s going to be a big winner. But when we look at who is a big winner, we can look and see, do they have something in common? And I don’t know if this is surprising or not. I guess it depends on your perspective. But who ends up being a big winner is a remarkably fundamental thing.

[00:21:46] Hendrik Bessembinder: They’re growth stocks, but not in the way that everybody uses the term growth stock. So, a lot of people use the word growth stock to mean a stock that has a high market value. Compared to the book value of its equity or the book value of its assets or something like that. With the reasoning for that terminology being the only reason it has that high market value is that investors are expecting rapid growth.

[00:22:11] Hendrik Bessembinder: Anyway, that’s not how I’m using the phrase growth stock. What I mean is it’s stocks that actually grow their fundamentals. So when I looked systematically at the data, and again, this was done at the decade horizon and said, okay, for the stocks that ended up being big winners in a decade, what can we say about them?

[00:22:27] Hendrik Bessembinder: Well, on average, they grew their fundamentals, they grew their assets, they grew their cash balance. Although, my guess is that the conversation is going the other direction there. The cash balance grew because things were going so well. Their assets grew, their cash balance grew. They were unusually profitable, just in terms of, say, income to asset ratio.

[00:22:48] Hendrik Bessembinder: But I ran some statistical horse races. Most important, net income grows. The proverbial bottom line. Companies that have rapidly growing net income tend to do really well. I don’t think that makes it any easier. Because predicting which firms are going to have rapid income growth is not an easy thing either.

[00:23:06] Hendrik Bessembinder: But I do think it helps to focus your thinking. If you can identify stocks that are likely to have rapid income growth, you’ve identified stocks that have a better than average chance of ending up on that winner list. But anyway, to me it was striking that to the extent we can find identifiable things in, again, I’m a data guy, so you know, I work with the observable data, I work with accounting data from Compustat, I work for prior return data from CRSP, among the things that I can sink myself, my teeth into as a statistical guy, income growth stands out as explaining which stocks end up being the big winners.

[00:23:39] Clay Finck: Yeah, and it is interesting if over a really long time period, if a company is increasing their earnings by 25 times, 50 times over a fairly long time period, odds are that’s going to deliver pretty strong returns. But say if they double earnings over the next five years, there’s no guarantee that’s going to deliver strong returns if it was already priced as a high growth stock and it’s P is a hundred.

[00:24:00] Clay Finck: So yeah, net income growth is certainly a important factor over these long, long time horizons. And I believe in one of your other interviews, you mentioned lower leverage as one of the things you found. And I would be interested in seeing the data on something like family run companies. I think companies that have a high degree of family ownership over many years, oftentimes you’ll see things like lower leverage.

[00:24:28] Clay Finck: They tend to think longer term conservative investments because they view this sort of as a legacy. So I’d be super interested if you’ve ever looked at any of data related to that.

[00:24:38] Hendrik Bessembinder: I’ve not looked at family owned companies, but I have a project I’m working on and I probably won’t be able to release it publicly for a little while yet, but it’s about CEOs, I’m naming individual CEOs, or we’ll be naming individual CEOs in the study.

[00:24:51] Hendrik Bessembinder: So it’s you know, people could be sensitive. So it’s, it’s gotta be, I gotta be very, very careful and get everything right before I release that publicly. But one thing I have, and we’ll be in the study when I release it is the companies with founder CEOs out before, not always, of course. But on average, companies with founder CEOs outperform.

[00:25:10] Hendrik Bessembinder: So that’s not exactly family owned companies, but somewhat similar. So hope to get that study completed in the next few months and get it released publicly.

[00:25:19] Clay Finck: And one idea, as I was reviewing your study, I was trying to wrap my mind around was just the length of the study, you know, 1926 to 2022 is a long, long time period.

[00:25:28] Clay Finck: And I think if you look at any long time period, almost every company eventually. Falls by the wayside. And I’m also not going to be an investor for the next 100 or 200 years. Most likely I might hold some stocks for say three years. I might hold some stocks for 10 or 20 years. And since you mentioned net income growth being such a key factor to stock returns.

[00:25:50] Clay Finck: I might see a business. Maybe it starts to mature. It starts to see really high levels of competition. Just things naturally changed in the marketplace. And then I might decide to exit that company, for example. I’d be curious to get your thoughts on how the findings might change if we looked at a shorter timeframe.

[00:26:07] Hendrik Bessembinder: So in many of the studies, I should clarify a little bit. There was this original study that had data through 2016. Then I’ve had a kind of series of follow up studies and extensions, but anyway, in at least some of those studies. I reported things not just for the full sample, the long run, but also the shorter horizons.

[00:26:27] Hendrik Bessembinder: So in these studies I would have reported on monthly returns, annual returns, decade horizon returns, and then full sample or lifetime, lifetime within the database that is. So you can find data on shorter horizons in several of the studies. The general pattern is there. Stock returns have positive skewness, but where it really becomes noticeable is at about the decade horizon.

[00:26:53] Hendrik Bessembinder: So let me back up just a little bit. Many people will be familiar with the normal distribution, the bell curve. We’ve actually known for a long time, at least since the 1960s, that stock returns don’t conform to the bell curve. In particular, they’re so called fat tailed. There’s too many really big returns.

[00:27:13] Hendrik Bessembinder: There’s too many, really small returns as compared to the bell curve. But that said, when you look at things at the monthly horizon, if you just do a plot of stock returns measured over the monthly horizon, it’s not real obvious that there’s a strong asymmetry. You can kind of see it, but it’s not real obvious.

[00:27:30] Hendrik Bessembinder: Even at the one year horizon, it doesn’t really jump out at you that there’s a strong asymmetry. But once you get to the decade horizon, which you look at returns compounded within a decade, it really does jump out that there’s strong asymmetry.

[00:27:46] Clay Finck: And I think most people wouldn’t be surprised to hear that stock returns in recent years has also shown that asymmetry.

[00:27:53] Clay Finck: So if we look at just data from 2017 to 2019, for example, just five companies accounted for 22 percent of the net wealth creation. So, in light of your findings in your more recent studies, do you think this makes the case for index investing stronger with things like technology and AI just concentrating in just these handful of companies?

[00:28:17] Hendrik Bessembinder: So yes, you’re right. The original study showed that there was a lot of concentration in wealth creation and the follow up studies have shown that that’s true. Becoming even more notable in, in recent years. And now does that strengthen the case for index investing or not? There’s a tension here. And I’ve been asked many times, does your study imply that people should be index investors or more broadly, should you be just broadly diversified by an old type investor, or should you be active and should be trying to pick stocks?

[00:28:48] Hendrik Bessembinder: And what I’ve said is that I really think that there’s a new ammunition here for both sides of that debate. If you were already inclined to think that you should be a diversified buy and hold investor, or that most people should be diversified buy and hold investors, you’d look at my study and you’d say, well, we have all the stuff that’s already in the textbooks and already been broadly discussed.

[00:29:09] Hendrik Bessembinder: Now, on top of that, this asymmetry means that if you just pick a few stocks at random, the odds are stacked against you. You’re more likely to lose than win from a few randomly chosen stocks. So anyway, some people, their takeaway is the evidence is stronger than ever that we should be passive, diversified investors.

[00:29:27] Hendrik Bessembinder: Other people look at it and say, well, we know the markets aren’t perfectly efficient. We know there’s at least some opportunities out there. And what this is showing us is how large the payoffs can be if you can successfully exploit your skills or be lucky, to be honest. But if you’re either lucky enough or skilled enough to be able to pick the winners, the payoff to doing that’s much bigger than we realized it was before.

[00:29:51] Hendrik Bessembinder: There’s some legitimacy to each side of that debate. The fact that the skewness and the concentration, if anything, seems to be growing in recent years, I think it just strengthens the extent to which each side has more ammunition. Whether it actually makes anybody move from one side to the other, you know, somebody who previously thought it’s a good idea for investors with the right skills to be stock pickers.

[00:30:16] Hendrik Bessembinder: Whether any of them will switch to be passive investors or vice versa. I doubt it. And I don’t know that it’s really changed my mind either. It’s just the strength of the arguments on each side keep getting stronger.

[00:30:28] Clay Finck: So if I were to argue maybe why someone should want to index, I would point to the fact that it can just be very costly not to own those top 4 percent of companies.

[00:30:38] Clay Finck: And if you don’t own some of those big winners, then it can just be very, very difficult to outperform. But on the other hand, I think one could also argue that there’s still a good proportion of companies more broadly that do outperform and you don’t necessarily have to own, say the magnificent seven to do well as an investor.

[00:30:58] Clay Finck: So maybe you own the top 0.1 percent of these companies. And you’ve mentioned previously, you’re personally a passive investor, and I’m sure many of your students want to enter the world of active investing. So I’m curious if there’s, what sort of advice you tell them or cautionary advice you tell them to help prevent some of the mistakes that stock pickers tend to make?

[00:31:18] Hendrik Bessembinder: Yeah, so I’m mostly a passive investor. I sometimes deviate from that just a little bit, but it’s rare and it’s when I perceive what seems to be an unusual opportunity, but it really comes down. It’s an economics phrase comparative advantage, and if you haven’t been sitting in microeconomics courses, a comparative advantage is actually really intuitive concept.

[00:31:39] Hendrik Bessembinder: What are you good at? In particular, what are you better at than the competitors? Some people have the right comparative advantage to be stock pickers or market timers. I’m not sure that that’s me. Although like I said, I have occasionally had done some active things and you know, they’ve seemed to work out well, but it could be hard to tell the difference between luck and skill, isn’t that, in a few tries.

[00:32:02] Hendrik Bessembinder: But it really comes down to comparative advantage. And then I would say, you know, dwell on the fact it’s not enough to be good. It’s not enough to be smart. You have to be better than your competitors. And there’s a lot of competition out there. So that’s, I think the place that people have to ask, that’s where they have to start.

[00:32:19] Hendrik Bessembinder: They have to ask themselves, do I think I have the comparative advantage to do this? You know, the comparative advantage at buying the stock with the right long term potential, that’s not already capitalized into the price. Or being able to time my trades. Comparative advantage in being able to live through those drawdowns that are likely to happen.

[00:32:39] Hendrik Bessembinder: Which is kind of a part of psychological question, but also a financial question to be able to live through drawdowns. So that’s the big question you got to ask yourself. Do I have the comparative advantage for those that do I say go for it? As a matter of fact, the economy needs you it would not be good if everybody was a passive diversified index investor I mean who’s again?

[00:32:59] Hendrik Bessembinder: I don’t know if the stock market’s efficient, but to the extent it is or it’s approximately sufficient It’s because active investors are buying undervalued things and selling overvalued things so If you believe you have the comparative advantage, go for it. The economy needs you, and if you’re right, you’ve got a shot at being rewarded.

[00:33:16] Hendrik Bessembinder: But here’s an analogy that I’ve brought up a few times. Professional athletics. The payoff, if you have the right comparative advantage, could be huge. But how many people have the right comparative advantage? I mean, I’ve always enjoyed basketball. I’ve played basketball recreationally, but a few random events, I ended up in some city leagues playing with some people who I had professional contracts, but we’re not in the NBA.

[00:33:40] Hendrik Bessembinder: This was their off season thing. And I marveled at how they could be so good, but not be in the NBA. So to be successful stock picker, you gotta be good and you gotta be better than your competitors. Comparative advantage is the key issue.

[00:33:58] Clay Finck: One of the things I see in some of the fund manager letters I read, of course, fund managers have an incentive to say that people shouldn’t index, of course.

[00:34:09] Clay Finck: But oftentimes I’ll read that they’ll point out the increased concentration in the index and point to that as a reason why index funds are riskier today than they were at different periods in the past. Have you ever looked at data and returns? At different points where market concentration tends to be higher.

[00:34:30] Clay Finck: And if that, you know, is reflective of what future returns might look like.

[00:34:35] Hendrik Bessembinder: So I’ve never done that in the data. And I think that actually it’s a desirable thing to put on the to do list. I have looked at it in kind of a more conceptual way, though. I have a paper that’s called Extending Portfolio Theory to Compound Returns.

[00:34:49] Hendrik Bessembinder: And maybe this is going to be obvious when I say it, but rebalancing periodically is it goes hand in hand with diversification in a sense. So if you started with a well diversified portfolio, but then you’re buying holds from there, we do have this asymmetry and some of the stocks are going to do really well, meaning they have a bigger weight in your portfolio.

[00:35:11] Hendrik Bessembinder: Essentially, that’s what we’ve seen with indices like the 500, the asymmetry showing up some of the stocks have done really well. They’ve got really heavy weights. Rebalancing by selling those winners and buying some of the stocks that haven’t done so well effectively restores your diversification. So, to the extent you thought diversification was a good idea in the first place, you might find that trimming your positions in the winners just kind of naturally goes hand in hand with the reasoning about why you diversified in the first place.

[00:35:40] Hendrik Bessembinder: So an index that has a very high weight on seven stocks is in some sense, not fully diversified.

[00:35:47] Clay Finck: I think back to many of the conversations I’ve had on the show and buying and holding great companies. It can be a big mistake to trim them oftentimes because of just how far they’re able to run. And here shortly, I’m going to be mentioning a couple of data points from your study, which us stocks generated the highest long term returns.

[00:36:05] Clay Finck: But before we get to that, has your research and your studies influenced how you’ve thought about valuation metrics? People often use like price to earnings, price to book, et cetera.

[00:36:17] Hendrik Bessembinder: I don’t know if it’s made any fundamental changes in how I think about them. I mean, they are informative. They are informative measures.

[00:36:23] Hendrik Bessembinder: We know that they’re of particular importance to value investors. Okay, to not try to buy stocks that are not at too high a multiple relative to their earnings. In the studies I did of winning stocks, the ones that ended up in the right tail, I did not find that those valuation metrics had any forecast power for who would end up in the right tail.

[00:36:44] Hendrik Bessembinder: So people may have been hopeful that that would be a big strong predictor of which stocks end up in the right tail, but I found essentially no forecast power. Okay, what I did find is that the stocks that did really well in a given decade had high valuation multiples at the end of the decade, but of course that’s totally different than saying those things can predict.

[00:37:03] Hendrik Bessembinder: It’s a competitive market. There’s no easy ways to reliably make money to the extent that those prices relative to underlines reflect that competition. I don’t think there’s any magic in those ratios. And my thinking really hasn’t been altered on that.

[00:37:17] Clay Finck: Yeah. So, I guess my point in the previous question, your most recent study was titled, which U.S. stocks generated the highest long term returns in the table of top performers is just mind blowing to say the least.

[00:37:30] Clay Finck: So the top performer Altria. And Altria, they compounded at 16.2% from 1925 to 2023. So that amounts to a whopping total return of 265000000%. So tying back to what I was saying earlier with price to earnings or whatnot, someone might have seen excessively high PE sometime along the way and said, hey, this stock’s too expensive.

[00:37:55] Clay Finck: Only to see it continue. Its massive run. Of course, it’s a extreme outlier in this database. One of your other top performers from the study was Vulcan Materials that compounded at 14 percent from 1925 to 2023. And that amounted to a total return of 39 million percent. And there’s a number of names on this list that our listeners would be familiar with.

[00:38:15] Clay Finck: You have Boeing, S&P Global, Coca Cola, Deere, Hershey, Johnson Johnson, etc. And the most surprising thing to me when I look at this is just the duration at which some companies are able to just keep growing and growing and growing. And it’s a reminder to me that if you see a great business, that has the ability to grow.

[00:38:37] Clay Finck: It likely can maybe run much longer than our intuition might expect. So I think our intuition might say a great company. It’s just sort of had its run in the last 10 or 20 years have been great, but how long can they really keep doing it? So that’s kind of what I look at and kind of take away looking at it.

[00:38:54] Clay Finck: I’m curious, some of your takeaways looking at this list of top performers.

[00:38:59] Hendrik Bessembinder: Yeah, so that study has a little bit of a backstory I think I mentioned that in several of my studies I had decided to focus on this dollar based measure wealth creation that I called it and at some point in the last few months Meb Faber who I think you know reached out to me. He says, you know, some people are asking me about which stocks for the highest best performers in just in terms of buy and hold returns. Do you have that handy?

[00:39:22] Hendrik Bessembinder: And I said, oh, sure. I can get, if I have that handy or I can get that pretty quickly. So I sent him the list and he mentioned it on Twitter. And then I started getting a lot of clarifying questions. So I thought, well, okay, I’m going to get these clarifying questions. I should just write up a short paper that describes how I computed these numbers, where they came from and such.

[00:39:39] Hendrik Bessembinder: So I did that a couple of afternoons and released it. And what I maybe didn’t completely anticipate is how interested people are in the list of the big winners. So anyway, that’s an interesting phenomenon in and of itself. The world wants to know about winners. But the reason I tell the back story is we got to keep in mind that these are the stocks that with the benefit of hindsight ended up at the top of the list as we touched on earlier in the podcast. There’s thousands of other stocks whose names we wouldn’t recognize who ended up with negative hundred percent returns but anyway, so we have to keep that in mind, these are the stocks that ended up being the winners. But anyway, I do think there are some lessons that came out of that study. Some stocks do keep compounding at high rates for long periods of time.

[00:40:27] Hendrik Bessembinder: Many of them won’t, you know, there’ll be stocks that had really good returns for a year or for five years and then it all falls apart, but it’s not impossible. So the fact that a stock has had a run up In and of itself is not a reason to sell it, nor is it a reason to buy it. I mean, it really comes down to fundamentals.

[00:40:43] Hendrik Bessembinder: The stocks had a big run up. Does its current price reflect its future potential? Has the current price gone beyond future potential or is it still under the future potential? I mean, ultimately it’s going to come down to those fundamental questions. I had another study that we haven’t touched on yet, where I basically looked at portfolios of stocks that hit certain multiples.

[00:41:04] Hendrik Bessembinder: Like they hit 5x, or they hit 5x twice to be at 125x, or they did it three times to get to 625x. And I just plotted what did the returns look like before and after hitting those multiples, on average. And of course, really good returns before hitting the multiple. That’s what got it to the multiple. What happens after it hits the multiple on average for portfolio stocks that hit the multiple, they just track the market on average.

[00:41:31] Hendrik Bessembinder: On average, a stock that’s had a run up does as well afterwards as a randomly picked stock. It’s competitive out there, but the study really shines the spotlight on the importance of time in the market. I mean, the very highest stocks in terms of their cumulative returns. For stocks that have been there for 70, 80, 90 years.

[00:41:50] Hendrik Bessembinder: Of course, you know, most of us won’t be personally invested for 70, 80 or 90 years. So I also looked at some things over shorter horizons, one year, five year, 20 year horizons, the really high performers. And when you see a stock that’s turned in 110 percent for three years, for example, that’s not going to persist in the long run.

[00:42:10] Hendrik Bessembinder: It never has. The stocks that ended up being like Altria or Vulcan Materials, they had good compound returns, 13%, 14%, 16 percent in that range, but not crazy good compound returns. If you’ve seen 50 or 80 or 100%, that’s great. That’s not going to persist in the long run. Just one other thing that I thought was interesting in that list.

[00:42:32] Hendrik Bessembinder: To be right at the top of that list of highest compound returns, you had to be listed, you had to be on the market for a long time. There were some stocks that wouldn’t describe, you wouldn’t immediately say, well that’s a sexy name. You already mentioned one of them, second on the list was Vulcan Materials.

[00:42:48] Hendrik Bessembinder: And so I said, I could probably that study pretty quickly. It didn’t do a lot of research into every stock that was on there. Some of them, of course, we already knew like say mowing. Speaking of drawdowns, by the way, back to Vulcan materials, just shortly after I released that study, the financial times did a podcast.

[00:43:03] Hendrik Bessembinder: Some of their own people talking about stocks on the list. Vulcan Materials is basically a building materials company. You know, we’re talking sand and gravel and things like that. But they did a very nice job of how pointing out the idea of a competitive moat, which of course, Warren Buffett likes to focus on a competitive moat that allows a company to continue to generate good income and growing income.

[00:43:24] Hendrik Bessembinder: Competitive moats could show up in a lot of different ways. One of which is having access to sand and gravel deposits in good locations. Because the stuff is too heavy to ship a long way. So having a nearby proximity to where it’s needed is a big competitive advantage. Anyway, that’s not exactly sexy or high tech, but nevertheless, Vulcan is number two on the list of alternative performers.

[00:43:45] Hendrik Bessembinder: So I think there’s some lessons there as well.

[00:43:48] Clay Finck: Yeah, you do make a great point about the moat just being so important. If you’re looking at a tech company. You know, it’s a much sexier industry is going to attract this industry overall is going to attract all these smart, smart people that are able to figure out how to disrupt some of these technology modes.

[00:44:04] Clay Finck: Whereas there’s some other names that a lot of these really smart people aren’t really attracted to the industry. So some of these established players can really gain a foothold and just grow and grow at steady rates for long periods of time. And you made another great point that when you buy a stock, you don’t get paid for anything of what they really did in the past year, it’s all about what they can do in the future. And the future is fundamentally uncertain pointing to yet another study you’ve done. A lot of our listeners are not based in the U.S. and they may invest in different markets. Of course, you’ve looked at international data.

[00:44:38] Clay Finck: So how does the international data look like the U.S. data in terms of skewness and how is it different anyway?

[00:44:45] Hendrik Bessembinder: That was, in my mind, one of the obvious follow up studies. So the original study was focused on the CRSP data, U. S. listed common stocks. It was a natural question to say, is this a global phenomenon, or is it something that’s somehow, for some reason, unique to the U. S.? So it took a little longer to do. There’s some challenges in building a comprehensive database of global individual stock returns. And I wasn’t able to do it for as long a horizon. I was being basically able to get a comprehensive sample that covered a 30 or a little over 30 years. But anyway, the punchline is when I went to the global sample, it looked just like the U.S. sample.

[00:45:21] Hendrik Bessembinder: As a matter of fact, in terms of the striking findings that most stocks underperform us treasuries and that the dollar wealth enhancement or wealth creation was concentrated at a few stocks that was even stronger outside the U.S. than in the U S. At this point, I’m not surprised. I just, I think I used this phrase earlier in the podcast.

[00:45:44] Hendrik Bessembinder: I think this strong skewness is just a fundamental attribute of investing in entrepreneurial economies. People often ask me, well, what do you think is going to happen over the next 10 years, the next 20 years? Of course, there’s a lot of things I don’t know about what’s going to happen over the next 10 years, 20 years.

[00:46:02] Hendrik Bessembinder: I don’t know how the overall market’s going to do. I don’t know which stocks are going to end up on the winner’s list. But I feel really, really confident in saying, there will be skewness over the next 10 or 20 years. There will be a relatively few stocks that generate the bulk of the performance over the next 10 or 20 years.

[00:46:23] Hendrik Bessembinder: I think the skewness or asymmetry is fundamental.

[00:46:26] Clay Finck: I guess I would mention, I’ll throw an idea out there and you’re free to take it wherever you’d like, but I’m not surprised that some of these international markets have more pronounced skewness, because I would think that just some of these maybe lower quality companies, or maybe some of these fraudsters are able to go public in a country like say China or India.

[00:46:47] Clay Finck: I’m not sure exactly which country that might apply to, but it seems like the U.S. seems to have stricter regulations about going public. I’m curious to hear your thoughts around that.

[00:46:56] Hendrik Bessembinder: Yeah. So I guess I wouldn’t jump right to a word like fraudster, but listing standards are definitely relevant here. So one of the findings back in the original paper was that the percentage of stocks that ultimately failed or more broadly, the degree of skewness in the returns was notably stronger for NASDAQ listed stocks or companies that were initially listed on NASDAQ as compared to companies that were initially listed on the New York stock exchange or in the old MX exchange.

[00:47:25] Hendrik Bessembinder: What that tells me is that NASDAQ had different listing standards than the more traditional exchanges did. I would hesitate to use the words, the wrong listing standards, because in fact NASDAQ stocks on average, once you take into account that Apple and Microsoft were among them, NASDAQ stocks on average actually did very well.

[00:47:47] Hendrik Bessembinder: But they had higher rates of failure and more skewness. So they had different listing standards. They were willing to list a younger and riskier stocks. I think the same phenomenon shows up internationally.

[00:47:58] Clay Finck: Well, this is great, Hendrik. It’s great to bring on a data guy to help us sift through this data and share some of the key findings from doing so. So I really appreciate you joining me here and sharing all this great research you’ve done. So please give a hand off to anyone who wants to read your studies or learn more about some of your work where you can direct them to.

[00:48:18] Hendrik Bessembinder: Sure. So once the papers get published, they’re usually behind the publisher’s paywall and that could be a barrier of course. But before the studies are published, they’re posted on a publicly accessible bulletin board called Social Science Research Network, ssrn.com. So all the papers we’ve talked about here are posted on ssrn.com. You can just search under my name or do a keyword search. And that includes the published papers.

[00:48:45] Hendrik Bessembinder: The final pre publication version is available on SSRN. All that’s changed after that is some formatting and occasionally some really minor changes in wording. So anyway, they’re all available on ssrn.com and if you’re interested, you can download them and happy to receive comments.

[00:49:04] Clay Finck: Wonderful. Well, I’ll be sure to get that linked in the show notes for anyone that wants to check it out.

[00:49:08] Clay Finck: There’s a lot of interesting stuff in there and add a lot of fun sifting through those for this conversation. So Hendrik, thank you for joining me. I really appreciate it.

[00:49:16] Hendrik Bessembinder: My pleasure. Thanks for having me.

[00:49:18] Outro: Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.