The more I study investing, the more I realize that one initial impression that I had about the stock market in general, and index funds in particular, turns out to be wrong: When I would look at index funds that returned 10% over a particular period, I initially assumed that most of the stocks delivered returns similar to that 10% mark—I figured most would clump together in the 8% to 12% range, and sure, you’d have a few outliers.
The more I dive into understanding stock market returns, the more I realize that there are often very focused “magic stocks” that are responsible for most of the results. For instance, when you look at Jeremy Siegel’s study of the top quintile of dividend stocks delivering the best total returns over the super long term, it is important to understand that one particular company—the old Philip Morris—played a key role in carrying the top quintile of highest-yielding dividend stocks to deliver the superior long-term returns that get written about.
In 1972, the brokerage house Kidder-Peabody put out its list of the now famous “Nifty Fifty” stocks that you could buy, take the stock certificate, put it in the bank, and then never think about it again. A lot of those companies were overvalued significantly in 1972, and the list writers had the unfortunate timing of writing it in the year preceding the ’73-’74 stock market crash that made them the subject of mockery (although I return fire by mocking those who call themselves long-term investors and then talk about isolated one or two year returns).
People who bought the Nifty Fifty at the time of the recommendation in 1972 did quite well, but it is important to understand that it is not because they all dominated, but rather, Wal-Mart was part of the Nifty Fifty companies chosen, per Forbes in 1996:
Still, you would have made good money putting equal amounts of capital into each of the 50 stocks on that Kidder, Peabody list in December 1972 and holding on for 23 years. The reason can be summed up in two syllables: Wal-Mart. This winner is up 15,854%. That is over ten times the gain in the next-best long-term holding, Hewlett-Packard.
So there’s something flukish in the results. Had Kidder omitted that one stock from its list–or had the Nifty Fifty investor sold Wal-Mart in, say, 1980, after a severalfold gain–the picture would be very different.
The numbers: If you had invested $1000 in each of the 50 Kidder stocks, your $50,000 would have turned into $427,000. An investment of $50,000 in the S&P 500 would have become just $276,000. But leave Wal-Mart off the list, and the not so nifty 49 merely ties the S&P. (Our computations exclude dividends but include gains earned from investing cash collected in mergers.)
Besides Wal-Mart, eight stocks on 1972′s list gained 1,000% or more. But 30 of them did worse than the market. One went all the way to zero: Standard Brands Paint slid into bankruptcy in 1993.
Other times, the exclusion of a particular stock can make the index returns be much worse than what they would otherwise be, as the Dow Jones removed IBM from its index during the WWII era. The data back then on the specifics is a bit murky, but this New York Times article gets the general point across:
Perhaps the most celebrated illustration of the Dow’s failure to represent the overall market traces back to a 1939 decision to delete International Business Machines from the Dow 30 list. I.B.M. wasn’t restored to the index until 1979. Norman Fosback, editor of Fosback’s Fund Forecaster newsletter, has estimated that the Dow would have been more than twice as high in 1979 had I.B.M. stayed in the index continuously.
It’s unclear when the Dow would have returned to its 1929 pre-crash high had I.B.M. not been deleted in 1939. In response to a request, an analyst at the indexes division of Dow Jones said that it was unable to determine the answer. But because I.B.M.’s stock was one of the best performers during the 1940s, greatly outpacing the Dow itself, it’s certain that its inclusion would have markedly accelerated the index’s recovery.
Without Altria, the studies on the top quintile of dividend stocks long-term performance would be much more disappointing. Without Wal-Mart, the long-term results of the Nifty Fifty lose their luster (as a cross lesson, the reason the Nifty Fifty didn’t work is because those companies traded at 40x and 50x earnings, much higher than market averages, and that is why high-quality assets did not outperform). And with IBM, the Dow Jones would have performed much better over the middle of the 20th century.
Making decisions because you want high yield, or because most stocks in a particular subcategory tend to do well, can be a recipe for much worse results than you would initially anticipate. It’s often a small handful of companies that do the heavy lifting. If you are interested in doing something like outperforming the S&P 500 Index Fund, then you need to find assets like Visa, Disney, and Becton Dickinson, and hold them for 20+ years. It’s about finding high earnings per share growth rates that are sustainable for a long period and purchasing them at fair (or even cheap if you’re lucky) prices. That’s the hard part, but if you succeed, it will change your life.
Originally posted 2014-12-22 08:00:08.