Choose Your Fighter

How hard is it to beat the market? Very hard, as it turns out. Not just for you and me but for professional stock pickers. There are three main reasons: firstly, fund managers charge fees, which means to beat the market after fees, they have to beat the market by even more before fees. It’s like starting a 100 metre race 10 metres behind everyone else. You are handing over your hard earned cash to a group of people in suits so they can put it in a fund which probably won’t beat the market.

Secondly, the very definition of a stock market (one of the greatest inventions of all time) means that the losers are continuously replaced with winners. Whilst an individual stock could go to zero, the S&P 500… well, I guess it could go to zero, but then we’re all stuffed.

Thirdly, market returns are highly skewed, as a recent Bloomberg article goes into (as I’ve often said, understanding maths is understanding the world). The 20 largest (mainly tech) stocks are contributing the most to returns in three decades; about 70% of the stocks in the S&P 500 lagged the index in the first half of 2023, which is the highest proportion since the height of the dot-com bubble in 1999.

The article states that fund managers aren’t stupid; it’s just that the market is skewed. This isn’t a new revelation. The infographic shows that out of 28,114 publicly listed stocks, the top 25 (0.08%) have created a third of all shareholder wealth since 1926.

Similarly, the bottom 25 stocks have destroyed a combined $1.2 trillion in shareholder value. Even Liz Truss would struggle to achieve that. It’s worth noting that, as of the time of writing, the bottom 25 includes tech “success” stories like Uber, Snowflake, Doordash and Rivian. Undoubtedly good products, with innovative tech which provide a service that consumers want. There’s a separate story here about stupid valuations (valuations don’t matter as much as people think) and IPOs at the bubble's peak, allowing VCs to exit before the paper wealth evaporates. As Larry Page used to profess, the commercial aspect of innovation is as important as the (tech) invention itself.

Speaking of venture capital, VCs use skewness to their advantage. Every VC knows the power law: venture capital returns are highly skewed, with a few investments delivering outsized returns (hello, Facebook and Google). These “home runs” generate returns many times the initial investment, easily enough to cover the rest of the losses.

In his 2022 shareholder letter, Warren Buffett notes: “Our extensive collection of businesses currently consists of a few enterprises that have truly extraordinary economics, many that enjoy very good economic characteristics, and a large group that are marginal” and “our satisfactory results have been the product of about a dozen truly good decisions.” He’s talking about skew!

If the fund managers have just learnt about skewed returns, then uh-oh.

I guess it depends on what type of investor you are. If you invest your money in private equity or venture capital, you need an exit event (a sale or an IPO). If, however, you are a business owner or think like a business owner - as Warren Buffett and Charlie Munger preach - what you want is lovely free cash flow. You want an increasing base of capital employed and a good return on capital employed. A laser focus on creating free cash flow and reinvesting it to generate future growth (and returns) is a crucial driver of the success of companies like Amazon, Alibaba, Apple, and Berkshire Hathaway. Between 1995 and 2012, Apple didn’t pay a dividend; it reinvested its earnings. And even then, the change in Apple policy was partly a result of Carl Icahn’s activist pressure.

An easy way to avoid this shareholder pressure is to not bother with shareholders and avoid being publicly listed. It’s rare, but possible, to become massive whilst being a private company - Cargill, IKEA, and INEOS are some private firms you may have heard of.

That’s not to say that we don’t want people or institutions who are good at making money. Do it the Warren Buffett way, and you’ll have the entire world respecting you (though I’d argue Berkshire Hathaway operates like a business owner, not an investor, though Warren and Charlie are indisputably investors). The world needs people like Buffett and Munger. The relatively dull yet ludicrously necessary world of pension funds attests to the fact. I want solid returns when I invest in index funds. I want my holdings to appreciate, thank you very much (not investment advice, yadda, yadda, yadda).

But there is one key distinction in my mind: those that go long and those that go short. Those that go long need growth and success to make a return. Those that go short need a destruction of value to make a return.

But you want the truth? The truth is that the VC world, the hedge fund world, and the pension world are all downstream of good business operators and entrepreneurs building products and services that people want and improve our world: invention, innovation and commercialisation. It’s the business operators and entrepreneurs that go long.

So choose your fighter: the rent-seeking hedge fund boss or visionary entrepreneur. I know who I’m with.

Thanks for reading!