Picking winning stocks matters

A couple of years ago, a stockmarket study by Hendrik Bessembinder and a team of researchers from Arizona State University caused a bit of a splash in the financial world. The 2017 paper looked at the performance of more than 26,000 US stocks over the 90 years from 1926. In all, concluded the researchers, the entire gain in the stockmarket over that period was "attributable to the best-performing 4% of listed stocks". Meanwhile, just under 60% of stocks returned less than the safest of safe assets (one-month US Treasuries, the equivalent of cash) over their entire lifetimes. In short, if you missed out on a handful of stocks, you were destined to make subpar returns, despite taking all the extra risk of owning stocks.

Last month, Bessembinder and team put out a new study. This time, they looked at the performance of 62,000 stocks from around the world, from 1990 to 2018. The findings were even more unnerving for stockmarket investors. Again, around 60% of stocks failed to beat one-month Treasuries. Overall, a mere 1.3% of listed companies accounted for "all the market gains" over that period, notes Barry Ritholtz for Bloomberg. And it was even worse outside the US, "with less than 1% of all equities driving all of the net appreciation in share prices". Five companies alone tech groups Apple, Microsoft, Alphabet (Google) and Amazon, along with oil giant Exxon Mobil accounted for more than 8% of the net shareholder wealth created by global stockmarkets. And as Ritholtz adds, the fact that we've seen two decent-sized boom and bust cycles over that period means it's less likely that the results are purely a fluke of some sort. So what should investors make of this?

It's yet another excellent argument beyond cost for favouring passive funds that merely track an index rather than trying to beat it. If history shows that a vanishingly small number of stocks in any given index actually make money for their owners over the long run, and we believe that this will continue into the future (past performance is of course, no guide to future performance, but it's the only one we've got), then the only way to be as sure as can be that you will benefit from these gains is to own all of the stocks in the index. It's also another reminder of the need to diversify.

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However, as Ritholtz points out, it's not all bad news for active investors. Perhaps such managers need to focus less on which stocks to buy, and more on which to avoid. "If screens could eliminate some of the long-term losers, it might not only improve returns, but could help to justify fees higher than simple indexing." Finding active managers who are able to pull this off consistently, unfortunately, is another matter.

I wish I knew what PEG ratio was, but I'm too embarrassed to ask

price/earnings (p/e) ratio

earnings per share (EPS)

To calculate it, you first find the p/e ratio, which is simply the share price divided by EPS. This gives you an idea of how much investors are currently willing to pay per £1 of historic or future earnings. You then look at how quickly earnings are expected to grow in the future (by using analysts' estimates, for example). To get the PEG ratio, you simply divide the p/e ratio by the expected annual earnings growth. Broadly speaking, a ratio below one is on the cheap side, and above one is expensive, with a PEG of one representing "fair value", according to Lynch.

The PEG ratio is seen by some investors as a better way to weigh up a company's value than relying on the p/e alone, because it takes growth into account. A rapidly growing company all else being equal should trade on a higher p/e than a slow-growing one. So the PEG ratio can be a useful tool for comparing companies in similar industries. For example, one company might have a p/e of 15, but expected earnings growth of 20%, giving it a PEG ratio of 0.75 (15/20). Its rival may also have a p/e of 15, but expected earnings growth of 5%, giving it a PEG ratio of three.

As with most ratios, the PEG is only useful in certain circumstances and in combination with other forms of financial analysis. A PEG ratio won't help you much with a slow-growing (or shrinking) company and earnings forecasts must always be taken with a hefty pinch of salt. Yet as a starting point to screen for promising high-growth companies, it can be a useful tool.