The Secret Life of Stocks
Want to hear a frightening statistic? In 1935 the average lifetime of a company in the S&P 500 was 90 years. By 2014 that metric had shrunk to only 18 years. Clearly, the staying power of America’s large corporations isn’t what it used to be.
Creative destruction is a very powerful force.
As investors we often confuse size with “staying power”, but that no longer seems to be the case. Economies of scale, often called an ‘economic moat’ that protects larger companies, doesn’t seem to have done a great job.
By all accounts the world is now changing faster than ever — Innovation and technology can quickly take down even the largest and most established corporate giants.
As investors, either passive or active, is this something we should be worried about?
Index Investors
While many index investors have a ‘devil may care’ attitude regarding the composition of their chosen index, they absolutely should care. These so called ‘passive’ index funds are anything but passive when dealing with the forces of creative destruction!
Let’s use a S&P 500 index fund for example — In the event that a company is removed from the index, the fund must immediately sell shares in the old company, and buys shares in the new business.
In the case of the share sale, this creates capital gains taxes. The index fund ends up being less tax efficient than other ‘Total Market’ index funds that wouldn’t be selling the shares. Investors end-up paying more in taxes than a completely passive investment.
This shifting of names in the S&P 500 happens surprisingly frequently too — in recent years anywhere from 15 to 23 companies have been removed from the S&P 500 annually.
Business And Biological Systems
Imagine for the moment that the business world is a jungle, teeming with life. Every company in this business world is an organism that lives, eats, and dies. Each organisms fills an ecological (business) niche, and fights to survive. Businesses in the jungle have to eat (income) or they will eventually die-out, like other biological systems.
In this mental model businesses also have to compete for food and resources. They must adapt to environmental change. Some will end up thriving , but others will struggle.
The parallels to an aggressive business world are obvious — “Only the strongest survive!”, and “Survival of the fittest!”, right?
Not quite.
Competition isn’t the end-all-be-all of survival. It turns out that Charles Darwin never actually said the phrase “Survival of the fittest”. The phrase is actually attributed to Herbert Spencer, not Darwin. In fact, modern biologist don’t actually use the phrase because it misrepresents Darwin’s actual process of ‘natural selection’.
What Darwin actually said in The Origin of Species was more akin to “Survival of the most adaptable“. The determining factor of an organism’s survival isn’t competition, but rather its ability to adapt to environmental changes and occupy unique biological niches.
I’m suggesting that the same holds true for businesses in which we might invest.
As an investor in both index funds and individual stocks, I try to invest as an owner and ignore market movements. I don’t want to be trading in and out of companies every few years and paying unnecessary taxes. I want investments with staying power than I can hold for decades!
Corporate Dinosaurs
Millions of years ago, dinosaurs roamed the earth. Many were GIANTS, and well adapted to compete for resources. Food sources were abundant (enabling their large size), and the environment was hospitable.
Life was pretty good for the dinosaurs, until one day it wasn’t…
66 million years ago (at the end of the Cretaceous period), an ecological event occurred that wiped the dinosaurs out. Scientists still debate exactly what the event was, but most theories seem to focus on a large asteroid hitting the Earth, causing dramatic environmental change.
The dinosaurs didn’t survive, but other more adaptable animals did. When environmental change came, the dinosaurs just couldn’t adapt fast enough. Small mammals survived and later thrived under the new conditions.
So what about the corporate world? Are large S&P 500 companies the world’s new dinosaurs?
Quite possibly! Large dominant companies, like IBM, Exxon, and Microsoft, have to focus on the largest multi-billion dollar niches to sustain themselves…making them highly dependent upon just a few economic niches.
When the next “economic asteroid” hits, those guys might be the first to go!
Adapting
Couldn’t a large company like Exxon adapt to a global shift to electric cars?
Potentially, but not without great difficulty. In most scenarios, Exxon wouldn’t be able to maintain the same market cap it commands today.
Instead, smaller nimble companies would fill the new niche faster.
This train of thought suggests that investing in a smaller company with a diversified income model might survive longer.
But predicting which niche is going to grow is nearly impossible. They could just as easily be wiped out. Self-driving cars? Electric cars? Drones? Smart Watches? Smart Homes? Wearable computers? Quantum computers? What innovation is going to be next? The list of possibilities seems endless.
How do the world’s great investors solve the problem of creative destruction? Answer: They don’t.
The world’s great investors are well aware of the complexity of investing in industries under dramatic change. They simply try to avoid the problem.
To get rich, you find businesses with durable competitive advantage and you don’t overpay for them. Technology is based on change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles. — Warren Buffett
Investing well, means finding great companies that will perform exceptionally not only today, but also tomorrow. As Buffett alludes to in his quote, if a particular niche encounters little change, it can be quite profitable.
There is a great book I’ve been reading that illustrates these points even further, The Innovator’s Dilemma by Clayton M. Christensen. In the book Mr. Christensen takes a deep analytical look at several industries and examines why success is so hard for innovative companies to sustain.
It’s an excellent read. If you have an interest in this topic, I highly recommend it.
Key Takeaways
Despite the difficulty of investing in companies with real staying power anymore, there are still some big takeaways that any investor can utilize from this thought exercise:
- Owners of index funds still need to worry about creative destruction. It can create unnecessary capital gains taxation.
- Bigger doesn’t always meant better. Being the biggest competitor doesn’t mean you’ll survive longer if you occupy the wrong niche when change comes.
- Business diversification in multiple niches might be a key to long term company survival.
- Small niches today might eventually become tomorrow’s big niches. (Example: electric cars)
- Making good long term investments means finding a company that succeeds in today’s environment, and will absolutely thrive in tomorrow’s.
- Great investors frequently try to avoid the problem of creative destruction. They avoid high-tech firms and invest in niches with little to no change.
[Image Credit: Wikipedia]
Mr. Tako, fascinating statistic on the average lifespan of a S&P 500 company! 18 years isn’t very long at all. I like the idea of identifying smaller niches which will become the larger niches. My bet on cool future tech? Virtual and augmented reality!
The problem with those Niches is they can change too. A great example is the railroads Buffet likes so much. The problem with them is there biggest driver tends to be coal shipments. The change in power away from coal has eaten their margins alive.
While the churn of indexes is indeed a concern for capital gains and for trading expenses of the underlieing fund, a churn rate of 15 out of 500 per year is actually fantastic compared to most active funds. If it concerns you a lot consider ETFs or putting the item in an account with deferred taxation.
Indeed! Thankfully for Buffett his railroad has a very diversified set of commodities it ships, if one goes out of vogue there’s always others to take its place. BNSF is also the lowest cost provider for moving goods across the United States.
That’s his durable competitive advantage. Over the last hundred years, or so that advantage seems pretty durable. I wonder if Facebook is going to last 100 years.
Dang it! I was excited that I’ve been slowly shifting a lot of my investments to index funds and then you throw this at me!
Just kidding, but that is interesting… I never thought about the tax inefficiencies that this could cause. Well, that’s just another reason for me to keep buying more real estate! 🙂
— Jim
Interesting post, and point(s) well made. Fortuntaly for us, the capital gain tax does not exist, so this makes index investing from that point not an issue. That being said, dividend growth investors are actually doing just this, selecting companies that are not really affected by niche concerns (e.g. food, utilities, everyday products, etc.).
What? You guys don’t have capital gains in the NL?
Nope, we are taxed on our wealth where the government assumes your ROI is 4% and they want 30% of that. In short it’s about 1.2% on your wealth (each year!). Sort of an expensive money manager 😉
Interesting topic, I do wonder the frequency that companies are added and removed from an index. Is it 1 or 2 per month? Or much higher than that?
Will have to add Innovator’s Dilemma to my to-read list. 🙂
The exact timing of when companies are removed is up to the index employees. I wasn’t able to find a formula or anything for how it works…which is a little concerning in and of itself.
I completely agree, having a total index rather than an index created by a publishing company (S&P) makes much more sense to me.
This is an interesting topic. You made me look into it a bit further, and I am not sure there is much of an issue with capital gains resulting from the turnovers. If you look at the Vanguard ETF for the last decade, it has not generated any capital gains, and before that they were quite small. While there might be a good bit of turnover in the S&P 500, it is the losing companies that are dropping out, and their sale might actually incur a loss rather than a gain.
https://www.bogleheads.org/wiki/Vanguard_500_Index_Fund_tax_distributions
That didn’t make any sense, so I dug a little deeper. The capital gains are masked by massive loss carry forwards. So yeah, no capital gains from that particular fund because they’re recovering from massive losses in previous years.
Frankly, I’d rather pay taxes than have capital losses.
Mr Tako – I appreciated your ability to address this topic without once using the term “black swan” … it was refreshing to stay with a fully-fleshed out dinosaur metaphor as opposed to going straight for the easy dark water foul trope.
Dinosaurs are more fun than black swans! But you’re quite correct — I’m thinking about survivability of investments through a black swan event.
If anyone is curious: https://en.wikipedia.org/wiki/Black_swan_theory
As well as survivorship bias: https://en.wikipedia.org/wiki/Survivorship_bias#In_finance_and_economics
To get rich, you find businesses with durable competitive advantage and you don’t overpay for them. Technology is based on change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles. — Warren Buffett
But then the wise man himself decided to buy IBM.
Definitely strange isn’t it. I cited them as a dinosaur on purpose. Buffett isn’t without his mistakes, but he’s right about 70% of the time.
I’ve heard several theories as to why he invested in IBM…and none of them make any sense to me. No matter how I look at it, I just don’t see a durable competitive advantage in IBM.
Really fascinating stats. I definitely agree that the entrenched companies are going to have difficulty maintaining market share. (I’m looking at you Coca-Cola, IBM and Insurance companies with driverless cars). I wish I was better at predicting winners when it came to the stock market. I would have selected Amazon, Facebook and Google years ago. Now I’d love to buy into Uber and AirBNB but they are both private. So I’ll wait until they potentially go public.
Really interesting article! “Making good long term investments means finding a company that succeeds in today’s environment, and will absolutely thrive in tomorrow’s”. – Totally agree with this. But probably this is the most difficult part of selecting the right stocks. Would you mind sharing some thoughts on how you personally do it?
I think this question would make a great post. Thanks for the idea.
That’s a great graph. I never thought about S&P 500 vs total index in that term before. Our passive index investment is in total market so whew! Around 20 companies per year seem pretty significant.
Shocking isn’t it!
The change in the speed of innovation is definitely interesting when considering which companies to invest in. I like the idea of Dividend Aristocrats as I can wrap my head around the concept more easily, which does not mean it is a good choice. Great post.