“Get your facts first, then you can distort them as you please.”  - Mark Twain
 
“There will always be arguments against indexing. If passive funds never existed, traditional fund managers would be collecting an additional $40 billion in annual fees…..I have never heard a sound argument against indexing advanced by active managers. Indeed, I can extend that lesson: I have never heard a sound argument against any investment practice coming from those would profit if they are believed.”                 -    John Rekenthaler  

The greatest change in investment management over the past 40 years has been the growing impact of index investing. Since 1975, passive investing has increased from .01% of total assets under management to 28% in 2017 and an estimated 50% by 2024[1]. This seismic shift between active and passive investing is driven by the simple facts that a.) index funds are far cheaper and b.) it is extraordinarily hard for an actively managed fund to outperform the greater markets.
 
I’ve written about this difficulty several times before, but a new paper[2] by Hendrik Bessembinder of Arizona State University has taken a new research angle that deserves discussion. I’ll let the paper’s abstract state discuss the answer to the paper’s title.
 
“Most common stocks do not (outperform Treasury bills). Slightly more than four out of every seven common stocks that have appeared in the CRSP (Center for Research in Security Prices) database since 1926 have lifetime buy-and-hold returns, inclusive of reinvested dividends, less than those on one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed companies.
 
It takes some time to process this paragraph. Since 1926 roughly 57% of all publicly traded stocks cumulatively earned returns less than a 30 day Treasury bill. This type of number goes against every core tenet we’ve heard most of our investing lives. “Buy stocks for the long run” or “a great way to lose your money over your lifetime is to only buy bonds”. And there are many more of these tidbits of wisdom. As usual there is some truth to these, but Bessembinder’s research certainly shows an interesting counterpoint to these claims.  
 
But the data gets more interesting as you dig deeper into the paper. Bessembinder finds that:

1. 96% of all equities over the past 80 years have added nothing to the stock markets’ total returns. 
2. More than half of the common stocks in the CRSP database delivered negative lifetime returns.
3. The single most frequent outcome (when returns are rounded to the nearest 5%) observed for individual common stocks over their full lifetimes is a loss of 100%.
4. A final kicker: When Bessembinder ran single stock models[3] only 27% of the time did the stock outperform a 1 month Treasury bill. 

 
Why This Is Important
 
Bessenbinder’s research was received with all the industry excitement that you might think. No investment manager (including this one) likes to read about how small your margin of error is and the long odds you face in picking successful investments. That is not to say outperformance isn’t possible. My partner John Dorfman has proven this over the years with an outstanding record. But putting aside the issues raised by the findings (mostly related to ego) there are some critically important findings that investors should take to heart.  
 
Shows How Hard Business Success Really Is
Many investors have actually never been owners of a business. For those who have had the pleasure (or agony as the case may be) of creating, building and growing a company, these owners know this is awfully hard work. It is estimated that 90% of all start ups close their doors within the first year. Finding a company that will continue to grow and create value over a 20 year time horizon is a difficult prospect. There are simply not too many prospects to be had in such a competitive marketplace. Bessenbinder’s research graphically demonstrates this.
 
Focus on the 4% Percent…….
Being able to identify the 4% of stocks that will generate long-term gains is extraordinarily difficult. Just like the individual who said they wanted to know where they would die so they wouldn’t go there, investors have to develop a process that gives them the best chance to find long-term compounding machines. Many exhibit similar attributes – prudent allocation of capital, deep competitive moat, product/services with a long-term strategy/need, and outstanding management that have a flexible strategy but strong core values. 
 
As Always Play Not to Lose
Once again it should be noted the most successful investors have been those who prudently invested with the idea of not losing any principal. Every investor will have a bad year or two. Such is the nature of investing. If you can avoid the truly catastrophic losses (such as those stocks who over their lifetime lost 100% of their value) the good years will take care of themselves.

It’s not often when a paper such as Hendrik Bessembinder’s gets published. His research looks at stock returns in a truly novel way. His research makes it clear there are two major ways in outperforming the market. You can take advantage of short term price dislocation versus a company’s value or use long term compounding to achieve market outperformance. This type of investing requires strong behavioral attributes, tremendous patience, and a deep knowledge of your investments. After finishing the paper, I think most investors will have a greater appreciation for long-term outperformance. Mark Twain said to get your facts first. I strongly encourage all investors do that and start by reading Bessembinder’s research.  Any distortion after that is all up to you.
 
 
DISCLOSURE: I own no stocks cited in this article.


[1] "Asset Managers - Global: Passive Market Share to Overtake Active in the US No Later than 2024," Moody’s Investor Services, February 2 2017

[2] “Do Stocks Outperform Treasury Bills?”, Hendrik Bessembinder, Arizona State University, August 22 2017.

[3] This model was based on holding a random stock for each month between 1926 – 2016. Each monthly return was then measured against the return on a 1 month Treasury bill. 

“The ability to make good assumptions about the future is very difficult in the present moment. One small mistaken estimate today can lead to truly horrendous results later. They say a bird in the hand is worth two in the bush. If that’s the case, then you better be really sure about the reproductive qualities of that small avian creature you are holding”.
                                                                                    H. Joseph Davis
 
Last month I wrote about the necessity in today’s markets to double your efforts looking for risk in your portfolio. One of the issues I discussed was, “when using a discounted cash flow model there are two assumptions that can really skew your valuation - estimated future free cash flow and estimated cost of capital. Both are easy to get wrong.” An outcome from getting either of these wrong is its effect on terminal value.
 
Terminal value isn’t the definition of your holdings after you die (though we all worry about that at some point). It actually means a company’s present value at a future point in time of all future cash flows when a stable growth rate is projected forever. Now before you put this article down muttering dark thoughts about this writer, I encourage you to really understand this model. I certainly can’t make the claim it will increase your investment returns, but I think it will make you a better investor. So stay with me here.
 
A common method to calculate terminal value is the Gordon Growth Rate.
 
               Final Year Projected FCF x (1 + Estimated Long Term Growth Rate)
                                          -----------------------------------
                       (Discount Rate - Estimated Long Term Growth Rate)
 
One of the things that jumps out using the Gordon Growth Rate calculation is the importance of estimating long-term growth rates. Getting that wrong can make a huge difference in your terminal value. In my 10 year discounted cash flow model any free cash growth created beyond the final (“terminal”) year makes up a tremendous amount of my estimated terminal value. This places a great deal of pressure on getting the long-term growth rate correct. The danger in this process is (correctly) assuming the company will continue to grow free cash at a healthy rate over the next 15 – 20 years. There aren’t many companies out there that meet this criterion. Coca Cola (KO) is likely to be selling more of its eponymous soft drink 20 years from now. On the other hand, it’s hard to know if Blink Charging (CCGID) will even be selling residential and commercial EV charging equipment at all 20 years from now.
 
The Impact of Moats on Terminal Value
 
One way to mitigate the risk of having a too high (or too low) estimated long-term free cash flow growth rate is to utilize the concept of moats. These are defined as a company’s advantages used to retain its competitive position and pricing power over an extended period in the future. This can be achieved through proprietary technology, patents, etc. Moats have a direct impact on future free cash flow growth as they provide companies with a long runway of steady expansion. Moats can be one of the most important measures when calculating terminal value. 
 
Sticking with the example of Coca Cola and Blink Charging, it’s relatively clear we could assign KO a very wide moat. With a 110-year history, enormous brand recognition, worldwide distribution network, and enormous market share, it’s likely Coke will still steadily grow its revenue over the next 20 years. Of course, there are threats to this moat even as I write - competitive pricing pressure, supply costs, demographic changes (less sugar required) and regulatory action such as the soda tax. The list is long and growing longer. But it’s important to remember Coke has survived two world wars, the Great Depression, and many other catastrophic events through its lifetime.
 
Blink Charging (CCGID) is an entirely different case. A company with a short history (public since 2012), Blink is dependent upon an evolving technology adoption along with a hyper competitive marketplace. With no industry leadership in place and battery technology facing constant pricing pressure from China, Blink has little to no competitive moat to help predict future cash flow.  With return on assets of -412%, no earnings, and negative free cash flow it seems any estimate you develop at a future free cash flow growth rate is highly volatile to say the least.
 
Which company is the easier to estimate the rate of future free cash flow growth? Perhaps someone with a deep understanding of automotive design, battery design, engineering requirements of the eco-balance of lithium ion storage, and government regulations can model Blink’s future better than most. For the rest of us I believe Coke’s wide moat makes it far easier to model free cash flow over the next 15-20 years.
 
Why This Matters
 
For anybody looking to calculate terminal value, the ability to be as accurate as possible in your estimates is critical. A seemingly small difference can have dramatic impacts on your final estimates. As a hypothetical example let’s use Acme Rubber Band Company. Our company currently trades at $3.00 per share, has 10M shares outstanding, generates $1M in free cash, and has a weighted cost of capital of 10%. I’ve modeled the company valuation using a 3%, 6%, and 9% future free cash flow growth rate. Seen below are the results. 

​Several things jump out right away. The first is that even utilizing a seemingly low estimate of 3%, over 60% of the estimated value of the company’s terminal value is derived from the estimated long-term FCF growth rate. At 9% nearly the entire terminal value is derived from the estimated long-term FCF growth rate. This is clearly not a time to make a serious mistake in your projections. Second, the value per share can increase dramatically if you bump up the estimated long-term FCF growth rate. In Acme Rubber Band the company goes from 17% above fair value at a 3% growth rate and dramatically swings to 76% below fair value with a 9% growth rate.  
 
Conclusions
 
The ability to accurately forecast future free cash flow can be greatly improved if a company has a wide competitive moat. All other things being equal, a company with a wide moat and consistently growing profits will be more valuable than a company that doesn’t have these characteristics. When using a discounted cash flow model, the ability to accurately predict future growth can significantly add to the chances for a successful investment decision. They say a bird in the hand is worth two in the bush. That may be true, but as Mr. Davis informs us, the ability to predict the future of a company’s growth accurately can really make your investments take flight.