Benzinga - by Sam Ro, Benzinga Contributor.
Stocks rallied to new all-time highs, with the S&P 500 setting a record intraday high of 5,505.53 on Thursday and a record closing high of 5,487.03 on Tuesday. For the week, the S&P gained 0.6% to end at 5,464.62. The index is now up 14.6% year to date and up 52.8% from its October 12, 2022 closing low of 3,577.03.
One of the most powerful aspects of the stock market is laid out in TKer Stock Market Truth No. 4: “Stocks offer asymmetric upside.“
A stock can only go down by 100%, but there’s no limit to how many times its price can multiply going up.
This phenomenon has been on full display with the rise of AI-hardware giant Nvidia (NASDAQ: NVDA). And this recent headline from Bloomberg says it all: “Nvidia’s 591,078% Rally to Most Valuable Stock Came in Waves.“
(Source: Bloomberg)
However, today’s discussion isn’t just about how you can make a fortune on a single stock.
Rather, it’s about how the performance of a few extraordinary stocks helps us better understand why the stock market broadly delivers the returns it does.
It also may help us understand what it’s like to be investing like Warren Buffett.
A Few Stocks Have Been Responsible For The Bulk Of The Market’s Returns For Decades History tells us that the stock market has usually gone up. But that doesn’t mean all stocks go up. Far from it.
In 2017, Arizona State University professor Hendrik Bessembinder made waves with his research paper that observed most stocks had been pretty crummy investments that underperform Treasury bills. Read the news coverage here, here, and here.
Bessembinder published another paper in 2020 with some updated stats that were similarly dismal. From the paper (emphasis added):
…The study includes all of the 26,168 firms with publicly-traded U.S. common stock since 1926. Despite the fact that investments in the majority (57.8%) of stocks led to reduced rather than increased shareholder wealth, U.S. stock market investments on net increased shareholder wealth by $47.4 trillion between 1926 and 2019. Technology firms accounted for the largest share, $9.0 trillion, of the total, but Telecommunications, Energy, and Healthcare/ Pharmaceutical stocks created wealth disproportionate to the numbers of firms in the industries. The degree to which stock market wealth creation is concentrated in a few top-performing firms has increased over time, and was particularly strong during the most recent three years, when five firms accounted for 22% of net wealth creation…When you consider Bessembinder’s stats alongside the fact that the market as a whole has historically generated an average of 8%-10% per year, you begin to understand that there’s a tremendous skew in the distribution of returns among individual stocks.
In other words: The market’s average returns are the result of a small handful of stocks generating eye-popping returns that offset the majority of stocks producing market-lagging returns.
In a report published in April 2023, S&P Dow Jones Indices (SPDJI) came to a similar conclusion after looking into the historical performance of the S&P 500. Specifically, they found that only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2002 to 2022.
“One of the most consistent characteristics of global equity markets is that returns are positively skewed — when graphed, they have a long right tail,” wrote SPDJI’s Craig Lazzara (emphasis added). “This is intrinsically logical, since a stock can only lose 100% but has unlimited upside.”
Many stocks deliver returns greater than 100%. (Source: SPDJI via TKer)
Over Lazzara’s measurement period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.
“In such a market, a manager’s success is dependent on his ownership of a relatively small number of strong performers,” he wrote (emphasis added).
Warren Buffett would agree with that sentiment.
‘It Takes Just A Few Winners To Work Wonders’ Buffett, CEO of Berkshire Hathaway, is often praised as history’s greatest investor. His legendary knack for picking stocks for Berkshire’ equity portfolio helps explain why the company’s shares have massively outperformed the S&P 500 over the years.
However, returns have not been evenly distributed across Berkshire’s stock holdings.
“Over the years, I have made many mistakes,” Buffett explained in his annual letter published in 2023 (emphasis added). “Our satisfactory results have been the product of about a dozen truly good decisions — that would be about one every five years.“
At the time, he walked through examples including Coca-Cola (NYSE: KO) and American Express (NYSE: AXP), which multiplied in value many times over while returning massive cash dividends. Read more about it here.
“The lesson for investors: The weeds wither away in significance as the flowers bloom,” Buffett said. “Over time, it takes just a few winners to work wonders.”
Warren Buffett speaks at Berkshire Hathaway’s 2024 annual shareholders meeting. (Source: CNBC)
In his annual letter published this past February, he discussed those positions again, saying (emphasis added): “Patience pays, and one wonderful business can offset the many mediocre decisions that are inevitable.”
Is What’s Happening Today So Different From History? The chart below from Bespoke Investment Group shows how the “Magnificent 7” tech names have been responsible for nearly half of the S&P 500’s returns since the beginning of the bull market in October 2022.
The Magnificent 7 have been a big driver of the S&P 500’s returns. (Source: Bespoke Investment Group)
The non-Magnificent names haven’t exactly been mediocre. But it’s clear that the strength of a few stocks have mattered.
And so I’d argue Bessembinder and Buffett’s insights can be applied to Nvidia and the megacap tech stocks and their effect on broad market returns.
Sure, the concentration of the stock market winners today is unusual in many ways. But the general concept of a minority of names driving the bulk of returns is nothing new. It defines why the broad stock market has climbed for years. And it also explains why Warren Buffett has been so successful.
A version of this post was originally published on Tker.co
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