Long-Term Investment? Doesn't Work All the Time
Key Takeaways
Buying to hold blue chips stocks for the long term is quite common advice, but data shows that in the long run only a handful of them retain their value, let alone increase it.
Large and strong does not necessarily correlate to good investment performance. The performance of stocks following the year they join category of ‘largest firms’ shows pretty lacklustre results.
Employing broad diversification ensures that you are able to access these large companies without being stuck with the losers.
It is better to be roughly right than precisely wrong.
Buy and hold blue chips? This is common investment advice. Blue chip companies are typically your established, profitable, and well-recognised corporations — your “too-big-to-fail” type of company. However, if you had held blue-chips over decades, you may notice that only a handful of them increase, or even just retain, their value. Most fall by the wayside. Why does this happen?
There was a good reason why a small company grew to be large, successful, and the large incumbent over time. It was likely that this corporation had a great idea, product, or competitive advantage over its peers. However, competitive advantages die over time and we have seen this happen time and time again. As that advantage withers away, so does the prominence, earnings power, and eventually, share price of that company.
Knowing you have a competitive advantage can actually be a bad thing because being successful reduces the impetus to explore other ideas or strategies, especially when those ideas conflict with what you are doing well.
Take, for example, the failure of Kodak. A massive and profitable incumbent in photography and film technology, actually had one of its engineers invent the first digital camera in 1975. A few years later, when Sony introduced its own electronic camera, Kodak conducted a detailed study on digital technology and its possible adoption. Even though the study revealed that digital technology would likely be mass adopted in the early 90’s, the Kodak management did not do anything —preferring to throw money into trying to improve their existing film business. As we know now, film has largely gone the way of the dinosaur and Kodak filed for bankruptcy in 2012.
For large incumbent companies, maintaining financial success becomes more important than honing or upholding the attributes that were vital to building up something great in the first place. Having nothing to lose is a wonderful place to be, but when you have to deal with shareholders who clamour for returns and dividends, it ends up superseding everything else.
Deutsche Bank published a report before, asking the management of large companies how they would prioritise cash flow in a downturn. The response?
Firms would first cut deferrable investment. This means less money for innovation and new ideas.
Then they would borrow money to pay the dividend, as long as they do not lose their credit rating. This means loading up on debt and exposing the company to bad leverage — leverage that does not improve productivity.
Next, they would sell assets at fair value and cut strategic investment. This further removes potential for further competitive advantages. Only when these actions are insufficient, would they resort to a dividend cut!
Finally, many large firms make the mistake of mis-identifying a temporary trend for a competitive advantage. Peloton, a maker of stationary bicycles, treadmills, and indoor rowers saw its demand skyrocket during the COVID-19 pandemic - with gyms closed around the world and many people preferring to stay home to exercise rather than being in the company of others. Former CEO John Foley noted that he was building a $1 trillion company and riding on its success, increased production rapidly and bought out competitors. However it wasn’t a competitive advantage but rather a temporary trend — as the world began to open up again, people decided that exercising at home wasn’t as fun anymore. The company’s shares are down -95% from its 2021 peak.
The chart below shows a breakdown of the largest US companies (the US stock market has the longest dataset for analysis) at the start of each decade since the 1930s. Some companies have stayed on top for a long time but one trend is painfully clear. This leadership does not last forever and the incumbents get overtaken by new trends and technologies.
The performance of blue-chip stocks following the year they become the largest firms shows pretty lacklustre results. Large and strong does not correlate to the investment performance. We should remember that any expectations about the future of the firm are already reflected in its current price. While positive developments for the company that exceed current expectations may lead to further appreciation of its stock price, those unexpected changes are not predictable.
So how do we, as investors ensure that we do not get stuck in this blue-chip trap? A simple evidence-based method is to diversify and to diversify broadly. Our core VaR and Everest portfolios employ this methodology to reduce unsystematic risks and to ensure that the investment portfolio is constantly refreshed with the latest investible universe. Employing broad diversification ensures that you are not stuck with the losers but instead always invest in what is the most relevant companies.
Broad diversification also gives you a higher probability of outperforming a standard global equity benchmark as the chart below shows. The full investment coverage of over 2,600 stocks gives an investor a 92% chance of outperforming the MSCI ACWI index over a 5 year period.
So whilst good investment advice typically urges one to “hold for the long-term”, it does not work all the time — especially if you are holding on to a handful of stocks. Long-term investment returns and outperformance only happens when you are invested in an appropriate evidence-based investment vehicle.
To find out more about how you can optimise your long-term investments, feel free to come and chat with us and we can show you how to do it.
