Morningstar - Q3 2021 - 14

Dispatches
EXHIBIT 4
Actual Market Versus Simulations The results mirrored each other, suggesting an
element of chance in the distribution of stock returns.
Annualized Gain for Largest 1,000 U.S. Stocks That Beat the Market Benchmark, January 2011
to December 2020.
Actual
32.4
Simulations
40%
33.2
25.2
25.6
21.4
21.6
9.8
Top 1%
Top 5%
Source: Morningstar Direct. Data as of 12/31/2020.
Top 10%
Median
9.4
10
20
30
With enough effort, I could probably have resolved
this query through equations. But with modern
computing power, there was no need. I simulated.
By drawing randomly from the 2011 returns,
2012 returns, 2013 returns, and so forth for each of
the 1,000 companies, I constructed an artificial
10-year stock history. This security never existed,
but it could have, because it was created from the
same material-that is, the same 10 calendar
years of 1,000 individual stock returns-as reality.
I repeated the process several thousand times
to generate 5,000 artificial 10-year performances
and then compared the distribution of the
clone stocks' annualized returns with those of the
actual marketplace.
and, thus, supports the growth investor's
argument. In Growth Dream, it is always wrong
to sell winners.
Value Dream flips Growth Dream on its head
by having each stock reverse its previous course.
The highest returner becomes the next year's
bottom-feeder, the silver medalist comes next,
and the class clown is crowned valedictorian.
This conduct minimizes the compounding
effect and, thus, supports the value investor's
argument. In the Value Dream, it is always
right to sell winners.
My point is that performances compound over
time, thereby exacerbating the differences
between one stock's returns and another's; this
must be considered when evaluating whether
investors should hold their stock market
winners, but the mere existence of compounding
does not settle the debate. What matters
is how the compounding occurs. If winners tend
to persist, as with Growth Dream, let them
ride. But if they backtrack, as with Value Dream,
harvest their profits.
By the Numbers
Happily, this inquiry can be tested. We can
examine how stocks actually behave. I compare
the percentage of the 1,000 biggest U.S.
companies that beat the Morningstar US Market
Index during each calendar year with the
14
Morningstar Q3 2021
percentage of such companies that outgained
the index over an entire decade.
The results seemed to support the case for Growth
Dream. In a single year, slightly less than half
the stocks exceeded the index's return. Over
the entire decade, one in five managed the feat.
That is, while most winners reverted to the
mean, a large minority continued to thrive. What's
more, 4% of companies more than tripled the
cumulative gain of the index. Surely that level of
success demonstrated genuine persistence.
It couldn't have simply been luck.
Then I thought again. If a coin is flipped 10
times, the most likely result is five heads and five
tails. However, that is scarcely the only possible
result. In fact, achieving an equal number of
heads and tails with 10 flips occurs on only 25% of
occasions. With many other sequences, either
heads or tails predominate, which might lead naive
observers to perceive a pattern that does not exist.
In other words, chance alone will create stock
market outliers. If there were no true persistence,
such that equity returns were purely random,
some stocks would nevertheless enjoy unusually
high compounded gains. Consequently, that
the amount of stock market winners shrinks
over time is beside the point. The critical question
is: Is this percentage more or less than would
occur by chance?
Bingo! Across the board, the simulations mirrored
the real world. This result, shown in EXHIBIT 4 ,
shouldn't be interpreted to mean that the market's
top performers became that way because they
were fortunate. Such a conclusion would ask too
much of the evidence.
What we can say, at least over the previous
decade, is that the distribution of U.S.
stock returns-that is, the manner in which they
compounded-is indistinguishable from
what would have been achieved by chance.
Which means that, absent the gift of foresight,
there's no reason for stock investors to hold
their winners. Yes, some of those securities will
continue to thrive and enjoy the virtuous circle of
higher returns compounding previously high
returns. However, if investors had chosen not to
retain their winners, instead shifting those assets
into randomly selected securities-as done
through the simulations-they would have fared
equally well.
If stock performances showed higher persistence
than would occur through chance, then
the odds would favor investors who follow Baillie
Gifford's advice to keep those that got you
here. But they do not. K
John Rekenthaler is a vice president with Morningstar
Research Services LLC. He is quick to point out that the
views expressed in Ivory Towers are his own.

Morningstar - Q3 2021

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