How to Bag Superior Returns from the Market’s Top 20% of Stocks

Article was originally posted here

I was listening to a Meb Faber podcast recently. Faber referenced a study by Longboard Funds’ Eric Crittenden that found 80% – eighty percent – of all stocks have returned 0.0% – zilch – since 1989.

That’s a pretty explosive “allegation,” if you will, so I immediately geeked out! I had to track down and read the study and run a few tests on the conclusions, to see for myself and for my readers.

The finding, which I confirmed independently, is shocking: The report, with its immense implications for investors, is correct.

Let me show you what I found. More importantly, let me show you how to avoid the sad, underwhelming fate of the folks who bought the 80% of stocks that are long-term duds…

A Few Companies Are Delivering a Lot of the Gains

Crittenden described his research like this: “We analyzed 14,500 active stocks between 1989 and 2015, identifying the best-performing stocks on both an annualized return and total return basis. Our research revealed that 1,120 stocks (7.7% of all active stocks) outperformed the S&P 500 Index by at least 500% during their lifetimes. Likewise, 976 stocks (6.8% of all active stocks) lagged the S&P 500 by at least 500%. The remaining 12,404 stocks performed somewhere in between.”

In plain English, for 26 years, from 1989 till 2015, all of the stock market’s returns – 100% – have gone to just 20% of listed companies. An investor who owned an index fund that did not include the top 20% of performers would have just broken even over that 26-year period.

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So, it’s obvious that to win this game, we need to avoid underperformers like the plague. That means one thing: defense. That’s far more important than playing aggressive offense all the time.

How to find those best defensive stocks?

Well, while digging into the numbers a little bit, I ran across original research from Joseph Piotroski. He advocated looking at price-to-book value as a kind of screen for stocks. Some debate the efficacy of that approach, but the evidence shows buying stocks below book value has historically been profitable for investors.

Piotrsoki found that, while there was considerable academic evidence that buying low price-to-book value strategies works, those returns came from just a handful of stocks. Specifically, he wrote, “The success of that strategy relies on the strong performance of a few firms while tolerating the poor performance of many deteriorating companies. In particular, I document that less than 44% of all high BM [book-to-market] firms earn positive market-adjusted returns in the two years following portfolio formation. “

Half of the stocks were losers; the odds were against the individual investor before the game even started.

I replicated Piotroski’s findings on my own. (This one podcast turned into an enormous time-sink, as you can tell.)

Those findings are pretty tough to argue with, and they’re resoundingly clear: Over the past 10 years, buying stocks below book value has been a profitable endeavor. The approach outperforms the market by about 30% annually. When we tweak it just slightly and look at only those companies with extremely strong financial positions, that outperformance grows to 600%.

That’s strange, because for years, investors have thought that the excess returns from small stocks were generated by the increased risk.

On the other end, some academics have made the case that the small-cap effect no longer exists.

Cliff Asness of AQR Capital Management took a look at this idea and found out that both groups were wrong. In his paper, “Size Matters If You Control for Junk,” he found that small caps still offered high returns – if you used some basic measurement to screen out the companies with poor financials and weak prospects.

Taken together, the academic research brings us to some significant conclusions – it points us toward the best investments and keeps us away from the duds.

What This Research Tells Us About Buying Stocks

If you can’t already tell, I take investing very seriously. I’m going to be owning a business, after all. I’m looking for a place to park and grow my hard-earned wealth – the fruits of my labor.

So, when examining a potential investment, the very first question you should ask is: What can go wrong?

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There are other big questions…

  • How much money can I lose if this brilliant, life-changing, rich-beyond-my-wildest-dreams idea doesn’t work out?
  • Can this company continue paying the electric bills and make payroll in a recession? Are there more financially sound competitors that can crush these guys’ hopes and dreams like a bug?
  • Do the insiders on the board have skin in the game? Will they suffer real financial pain in the business fails, or do they just walk away to the next adventure unscathed?

This is hard to do much of the time. We all love a good story, and it can be easy to get excited and chase that “next big thing,” all the while thinking only of how much we can make from the deal.

Fun as it is, it’s precisely the wrong thing to do.

One of the most successful investors of all time, Henry Kravis of KKR, shared a piece of advice given to him by a business friend of his father; it’s advice that has dominated his investment process. His dad’s friend told him when he was starting out in the world: “Never worry about what you might earn on the upside. Always worry about what you might lose on the downside.”

The odds are against you out of the gate, and your emotions make it even more difficult than it needs to be to make money in the stock market. They make it all too easy to burden yourself with the 80% of stocks that are, ultimately, garbage.

The only way to keep your emotions in check and get the odds solidly back in your favor is to use the numbers. Numbers cut through all that noise, all that BS, and help you focus on the fundamental and financially sound companies that will be around for a long time and help you buy them at bargain prices.

You can do the research yourself – on the off chance that, like me, you love poring over endless streams of numbers and data – or you can click here and learn how to get my best stock research recommendations.

Making money in stocks is not just about offense – it’s not just about finding the gems. Taking out the trash is also critically important.

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