If you have a broadly diversified portfolio, you're probably holding far fewer good stocks than you think.
Chances are your equity earnings, like the stock market itself, are dependent on the runaway returns of a precious few stars counteracting the mediocrity that characterizes the vast majority of public listings.
Much has been made lately of the dominance of a few tech champions in upholding U.S. stock indexes. A similar trend is afoot in Canada, with just seven names responsible for all of the index returns so far this year.
But this pattern is hardly unusual. Some recent studies, in fact, indicate that the concentration of long-term gains in a small number of stocks is almost always the case.
"Less than 4 per cent of common stocks account for all of the net stock market gains," said Hendrik Bessembinder, an Arizona State University finance professor who looked at nearly a century of U.S. market data. "The other 96 per cent of stocks collectively matched Treasury bill returns over their lifetimes."
With long-term winners so scarce, his findings make the challenge of stock picking look all the more formidable. And, to some, they reaffirm the wisdom behind index investing.
"To ensure you capture the contributions to gains that such leaders can make, indexing gives you the best fishing net," said Yves Rebetez, managing director and editor of ETF Insight.
It hasn't been a great year so far for Canadian equities in general, with the S&P/TSX composite index having generated a total return, which accounts for price increases plus reinvested dividends, of just 2.1 per cent.
But active investors who didn't have exposure to a particular handful of Canadian large-cap stars might not have even done that well. Excluding just seven big winners from the S&P/TSX composite index would put the index in negative territory on the year (see table below).
U.S. investors, meanwhile, who didn't have exposure to the high-flying tech giants would be much more likely to be trailing the market this year.
The top contributors to S&P 500 index returns this year are Apple Inc., Amazon.com Inc., Facebook Inc., Microsoft Corp., and Alphabet Inc. Those five stocks collectively are responsible for nearly one-third of the index's 10-per-cent total return this year, according to data provided by Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.
But investors plowing money into the biggest stocks aren't just chasing performance, they're chasing profits, Mr. Rebetez said.
"These names are not dominating based on people just throwing money at the biggest names. They also happen to be winning the battle for market share."
A recent Globe series has examined the implications of a decline in public listings seen over the last several years in the Canadian and U.S. stock markets. Fewer and fewer companies are choosing to go public, while the roster of existing stocks is being thinned out by a wave of mergers and acquisitions.
The combined effect of dwindling IPOs and industry consolidation has resulted in a concentration of size among the market's biggest names. And they are able to use that strength to control an increasingly large share of the market's total earnings.
Just 30 firms accounted for half of all the profits generated by U.S. public companies in 2015, according to a recent National Bureau of Economic Research (NBER) working paper.
Those same companies' stocks also appear to be providing the fuel for overall market performance.
"Industries with a declining number of firms experience significant abnormal stock returns," according to a recent study written by Yelena Larkin, assistant professor at York University's Schulich School of Business, along with Rice University's Gustavo Grullon and Cornell University's Roni Michaely.
An investment strategy focused on stocks in industries with the highest degree of consolidation would have generated excess annual returns of 8.5 per cent per year over the period of 2001 to 2013, the study found.
While consolidation may help explain today's market leadership, the concentration of gains among a select few is no new trend.
Prof. Bessembinder's study looked at the performance of 26,000 stocks listed on U.S. exchanges between 1926 and the end of 2015. Just 86 of those stocks generated half of the market's wealth creation over the decades. Another 900 or so accounted for the rest.
The sheer scarcity of elite stocks, and the lottery-like odds of correctly identifying them, illustrates how hard it is to beat the market.
"The results help to explain why active strategies, which tend to be poorly diversified, most often underperform," Prof. Bessembinder wrote.
On the other hand, the form of diversification most commonly prescribed for the masses these days – index investing – necessarily involves exposure to a horde of underperforming stocks.
"If there are only a handful of stocks at any given time moving those indexes, you're really fooling yourself," said Norman Levine, senior portfolio manager with Portfolio Management Corp. in Toronto. "You're actually owning a lot of bad stocks."
A smart active approach can successfully shield portfolios from the biggest losers, Mr. Levine said. "If you own the TSX index, you own Home Capital. We don't," he said. "We didn't own Nortel, way back when. But the index owned it. We didn't own Valeant, more recently. But the index owned it."
And yet, the market's best stocks typically manage to generate returns so dazzling, they more than offset the damage collectively done by the market's losers, big and small, at least according to Prof. Bessembinder's findings.
So influential are the market's biggest leaders, he said, that they can make a winner of a portfolio full of lousy stocks.
These seven companies have accounted for all of the S&P/TSX index's total returns, year-to date
|Index/Companies||Total Return YTD (%)||Contribution to TSX Total Return (%) *||Cumulative Contribution|
|S&P/TSX Composite Index||2.1%|
|Canadian National Railway||19.6%||31.0%||31.0%|
|Royal Bank of Canada||5.3%||16.9%||47.9%|
|Brookfield Asset Management||17.5%||15.5%||63.4%|
|Bank of Nova Scotia||5.2%||10.8%||74.2%|
|Waste Connections Inc.||22.9%||9.4%||83.6%|
|Rogers Communications Inc.||22.3%||9.4%||93.0%|
|Restaurant Brands International||24.3%||8.5%||>100%|
Source: Bloomberg. * figures do not add up to 100 due to rounding