What drives investments returns?

What drives investment returns?

Here is a piece from another good communicator at Dimensional – one I have met (and he’s as thoroughly entertaining as he is decent). Weston Wellington (what a great name!) penned this piece for Dimensional and I have permission to share it with you, I think it provides some useful insights. I hope you agree. As ever, there are American references, but if we are looking after your portfolio, you will recall that we invest globally and that the US market makes up about half of the world stock market by valuations. Over to Weston…

A recent news item reported that Frederick Smith intended to step down as Chairman and Chief Executive Officer of FedEx Corp., the largest air freight firm in the world.

FedEx for a Mr Smith…

As a Yale undergraduate in 1965, Smith wrote a term paper for his economics course outlining an overnight air delivery service for urgently needed items such as medicines or computer parts. His professor was not much impressed with the paper, but after a stint in the Air Force, Smith sought to put his classroom idea into practice. He founded Federal Express (now FedEx) in 1971, and one evening in April 1973, 14 Dassault Falcon jets took off from Memphis airport with 186 packages destined for 25 cities.

In retrospect, it was not an auspicious time to launch a new venture requiring expensive aircraft consuming large quantities of jet fuel. Oil prices rose sharply later that year following the Arab states’ oil embargo, and the US economy fell into a deep recession. Most airlines struggled during the 1970s, and Federal Express was no exception.

But Smith’s idea found favour with customers, and 49 years after its initial deliveries, the firm is a global colossus with over 650 aircraft, including 42 Boeing 777s—each of which can fly more cargo than 100 Falcons. Although it took over two years to turn its first profit, FedEx became the first start-up in American history to generate over $1 billion in revenue in less than 10 years without relying on mergers or acquisitions. The journey has proved rewarding for investors as well—100 shares purchased at the initial offering price of $24 in 1978 has mushroomed to 3,200 shares worth over $718,000 as of May 31, 2022.*

Fred Smith’s idea is just one example of ingenuity that humans have exhibited for centuries. Sticks and stones led to hammers and spears, the wheel and axle, the steam engine, and eventually semiconductors and jet aircraft. The invention of writing made it possible to store and hand down information from one generation to the next, enabling ingenuity to compound into an ever-increasing body of knowledge. Although we often associate innovation with clever new technology, some remarkable developments have required little more than astute powers of observation. The curse of smallpox, for example, has afflicted humans with death or disfigurement for thousands of years. English doctor Edward Jenner noticed that milkmaids who had previously experienced cowpox did not catch smallpox, and in 1796, he took material from a milkmaid’s cowpox sore and inoculated James Phipps, the nine-year-old son of his gardener. Later exposed to the virus, Phipps never developed smallpox, and Jenner published a treatise on vaccination in 1801. Smallpox vaccines gradually eliminated the disease in countries around the world, and the last known case was reported in Somalia in 1977.

ONE INNOVATION PAVES THE WAY FOR OTHERS

Charles Lindbergh took off from Long Island for his historic transatlantic flight to Paris on May 20, 1927. That same day, J. Willard Marriott opened a nine-stool lunch counter serving cold A&W root beer in Washington, D.C. Ten years later he began to supply box lunches to airlines flying from nearby Hoover airport and 20 years later opened the world’s first motor hotel in Arlington, Virginia. Today, Marriott is the world’s leading travel firm, with over 8,000 hotel properties in 139 countries.
The now-ubiquitous microwave oven can trace its roots to a happy accident. While working on radar equipment in 1945 for Massachusetts-based Raytheon, electronics engineer Percy Spencer noticed that the chocolate bar in his pocket had suddenly melted. His curiosity led to the introduction of commercial-grade water-cooled microwave ovens in 1947 costing thousands and ultimately to countertop units available today for $99.
Frustrated by lengthy delays associated with loading and unloading cargo ships, trucking firm owner Malcolm McLean launched a shipping service in 1956 using standardized steel containers of his own design. Met with great scepticism when first introduced, his idea for theftproof stackable cargo boxes eventually transformed the global shipping industry—and world trade—by slashing dockside loading costs over 90%.
On June 26, 1974, cashier Sharon Buchanan inaugurated the era of barcode inventory tracking when she scanned a pack of Juicy Fruit gum bearing a Universal Product Code at Marsh Supermarket in Troy, Ohio. Barcode scanners eliminated the drudgery and inevitable mistakes associated with manual entry by checkout clerks and provided store managers with powerful tools to track sales trends. As retailers such as Home Depot, Ross Stores, and Walmart expanded throughout the country in recent decades, barcode technology played a key role in matching inventory with local preferences at each location.
In March 2022, a 20-year-old woman born with a small and misshapen right ear received a 3D-printed ear implant made from her own cells and shaped to precisely match her other ear. Although experimental, the procedure represented a significant advance in tissue engineering and could eventually lead to artificial organs such as lungs or kidneys.

THE BENEFITS OF INNOVATION ARE WIDELY DISPERSED

The benefits of innovation are widely dispersed throughout the economy, often in unpredictable ways. Apple Inc. became one of the world’s most valuable companies based on its clever marriage of the computer and the telephone; both iPhone users and Apple shareholders reaped substantial rewards.

On the other hand, suppose your fairy godmother had told you in 1935, at the dawn of commercial air travel, that this tiny sector of the economy would eventually become a gigantic industry with millions of passengers flying every year—including some flying from breakfast in New York to Los Angeles for dinner. What would your prediction be for industry pioneers such as TWA or Pan American? Most likely, bountiful prosperity and rewarding stock market performance. The millions of passengers materialized. The profits did not. Both firms went bankrupt. So innovation itself does not ensure prosperity in every case.

That’s why it makes sense to diversify. Investors are often tempted to focus their attention on firms that appear poised to benefit from innovation. But it’s difficult to predict which ideas will prove successful, and even if we could, it’s unclear which firms will benefit and to what extent. Software giant Microsoft has been a big winner for investors, with the share value soaring more than 100-fold over the 30-year period ending May 31, 2022. Discount retailer Ross Stores proved even more rewarding, as the stock price multiplied over 189 times during the same period. One firm developed powerful computer technology and the other applied it.

Civilization is a history of innovation—curious minds seeking to improve upon existing ways of meeting mankind’s wants and needs. Public securities markets are just one example of such creativity, and they have a history of rewarding investors for the capital they supply to fund such innovation. But a significant fraction of the wealth created in public equity markets typically comes from only a small number of firms; therefore, we believe owning a broad universe of stocks is the most effective way to participate in the rewards of ingenuity and innovation, wherever and whenever it takes place.

Footnotes

*Stock split information sourced from FedEx investor relations website. Stock price information provided by Bloomberg. This is not taking into account cash dividends or any reinvestment.

You can read more articles about Pensions, Wealth Management, Retirement, Investments, Financial Planning and Estate Planning on my blog which gets updated every week. If you would like to talk to me about your personal wealth planning and how we can make you stay wealthier for longer then please get in touch by calling 08000 736 273 or email info@solomonsifa.co.uk

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Picking Winners – Financial Myths

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Picking Winners – Financial Myths

Most of the financial services industry thrives on inertia and misplaced trust. The investing world can be broadly broken down into two categories – active or passive management of money. The terms are not helpful but can broadly be best described as active management is where Fund Managers attempt to outperform the market by use of skill, philosophy and information. Passive management basically says this is possible, but impossible to do with any repeatable success, so invest into the entire market (or index) to obtain the market return.

There are skills, systems and processes needed within passive management if truth be told, particularly when an index is forced to alter its constituents (much like the end of season promotions and relegations). However, costs are generally much lower – unless you are unfortunate enough to own a Virgin Money Index tracker. Generally active funds are more expensive – considerably. This it is argued, is due to better performance.

Anyhow, research from American Dimensional Fund Advisers, who rather pride themselves of academic research and evidence, recently concluded their study of US funds available to US investors. OK, its America not the UK, but given that the US is roughly 8 times the size of the UK stock market, let’s use it as a better sample.

Coldplay - A Rush of Blood to the Head No.1 Album in 2002

Atomic Kitten - The Tide is High No.1 single in 2002

The Unvarnished Truth

The evidence looked at equity funds and Fixed Interest Funds over 5, 10 and 15 years (2002-2017). Given that most people are investing for their lifetime, though behave as though they do so for about 12 months, these are sensible starting timeframes for such research. For the sake of brevity, I will discuss their equity fund findings (the results were much the same for both asset classes).

Of all the funds available, only 14% to 26% outperformed their Morningstar category index. The longer the time frame the lower the number that outperformed. So, in simple terms about 1 in 4 outperform over 5 years, 1 in 5 over 10 years and about 1 in 7 over 15 years.

Survival of the Fittest

However, even if it was as simple as simply picking funds on that basis, you are more likely to have picked a fund that closed. Over 5 years 18% of the funds did not survive (about 1 in 5). At 10 years this rose to 42% failing to survive (1 in 4). At 15 years, well just 51% of the funds you could have chosen from survived. That’s 1 in 2.

Top of the Pops Investing

As many advisers and most online sites promote and select “top performing funds” it may interest you to know that a Fund Managers historic performance does not ensure a decent future performance. The data revealed that top quartile performance for consecutive 3-year periods occurred on average between 17% and 33% of the time. In short, not many sustained even a short-run, or strong track records failed to persist. Coldplay and Atomic Kitten both had good years in 2002 (when the data range begins). Who remains “successful”?

As stated, an often-cited argument is that active funds cost more because they perform better (we have established that some do – 14% of them over 15 years). Higher costs mean better results, right? Well not according to the evidence. Those with high charges (fund manager costs) with an average expense ratio (AER) of 1.93% almost entirely underperformed (94% of them). Those with the lowest costs (AER of 0.83%) delivered better results, with 25% of them outperforming.

The research also found that trading costs also impacted results (unsurprisingly). Some Fund Managers changed their portfolios almost entirely, the more they did and the longer the timeframe, the fewer that beat their benchmark. Yet this is typically claimed to be their true skill. Only 9% of high turnover funds beat their index over 15 years.

Hey Big Spender…

I have been in this game for quite some time, but it doesn’t need much experience to learn that those with more money have more money to spend…. On their version of reality (marketing) which is why many advisers, Product Providers and media swallow the myth that active management costs more because it delivers more. It can, but only in a very small number of cases and the chances of selecting such funds is virtually non-existent when most look at 3-year top quartile performance data.

There is another way, a better, cheaper way. We call it low-cost investment techniques rather than passive investing, because there is nothing passive about it. High costs and excessive turnover are likely to contribute to underperformance. You can avoid this completely, if you want to.

Dominic Thomas
Solomons IFA

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