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EOTM: Special Edition

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1 EYE ON THE MARKET • J.P. MORGAN E y e o n t h e M a r k e t J . P . M O R G A N The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position Executive Summary There are many Horatio Alger stories in the corporate world in which an entrepreneur or CEO has the right idea at the right time and executes brilliantly on a business plan. But history also shows that forces both within and outside management control led many of their businesses to suffer serious reversals of fortune. As a result, many individuals are known not just for the wealth they created through a concentrated position, but also for the decision they made to sell, hedge or otherwise take some chips off the table. In this paper, we take a look at the long history of individual stocks, and at the risks and rewards of concentration. I first analyzed this topic in detail around ten years ago; since that time, while some things have changed, the overall song remains the same. Over the long run, some companies substantially outperform the broad market and maintain their value. However, the odds have been stacked against the average concentrated holder: • Risk of permanent impairment. Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value. For Technology, Biotech and Metals & Mining, the numbers were considerably higher. • Negative lifetime returns vs. the broad market. The return on the median stock since its inception vs. an investment in the Russell 3000 Index was -54%. Two-thirds of all stocks underperformed vs. the Russell 3000 Index, and for 40% of all stocks, their absolute returns were negative. • After incorporating the issue of single stock volatility, we find that 75% of all concentrated stockholders would have benefited from some amount of diversification. Another sobering observation: since 1980, over 320 companies were deleted from the S&P 500 for business distress reasons, which implies a lot of turnover. This should not be a surprise: capitalism is based on competition, creative destruction and reinvention. While globalization (and in particular, China's acceptance into the World Trade Organization in 2001) expanded the opportunities for individual companies, it also increased their competitive, regulatory and operational risks. We start with some empirical analysis, and follow with case studies by sector. While the losses on the stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood the company's management, its board of directors, research analysts, credit rating agencies and its employees all firmly believed in its long-term success. Michael Cembalest J.P. Morgan Asset Management 1

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