The Risks And Rewards Of A Concentrated Stock Position – The steady drumbeat of creative destruction in the S&P 500

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Thisis a good one! The Risks And Rewards Of A Concentrated Stock Position via JPMorgan

The steady drumbeat of creative destruction in the S&P 500

A simple place to start when thinking about the risk of concentrated stock positions: how often do their circumstances change? Since 1957, the S&P 500 has served as a proxy for 500 of the largest, most successful US-domiciled companies. We have compiled a detailed history of its additions and deletions since 1980, which forms the basis for this part of the analysis. To be clear, not every S&P 500 deletion was the result of a “problem stock”. Actually, most deleted companies were not the result of a problem, and reflect benign index removals because: they were acquired at a premium to their current price; they merged with other companies in the index; or, they reincorporated outside the US.

After sorting through the benign deletions, we focused on the rest: the S&P 500 deletions that were a consequence of stocks that failed outright, were removed due to substantial declines in their market value, or were acquired after suffering such a decline. As shown below, there were over 320 of them since 1980. The pace of distress-based deletions rises during a market crisis or recession, but there is a steady pulse of business failure during the entire business cycle. Consumer Discretionary, Technology and Financials accounted for the majority of distress-based deletions.

The spike in index removals during recessions is accurate in time, but misleading in terms of business risk. Many such companies were much riskier than they seemed during good times, and when the tide went out with the economy, their operational, financial and competitive weaknesses were revealed.

Falling from grace: catastrophic losses on Russell 3000 companies

The prior section looks at stocks that were deleted from the S&P 500. However, the “distress” rate of individual stocks is higher than the index deletion rate, since there are stocks that suffer substantial price declines from which they do not recover, irrespective of whether they remain in an index. And what about small and mid cap stocks which are not captured by the S&P 500?

To broaden our analysis, we analyzed all stocks that were members of the Russell 3000 at any time from 1980 to 2014, a database of 13,000 large cap, mid cap and small cap stocks. We then defined what we believe a concentrated stock holder would see as a catastrophic loss: “a decline of 70% or more in the price of a stock from its peak, after which there was little recovery such that the eventual loss from the peak is 60% or more.” How often does this take place? As shown in the table, 40% of all stocks suffered such a permanent decline from their peak value. Remember, we are not talking about temporary declines during the tech boom-bust or during the financial crisis, but large, permanent declines that were not subsequently recovered. Technology, Telecom, Energy and Consumer Discretionary had the highest loss rates. In terms of subsectors, Biotech (part of Health Care) and Metals & Mining (part of Materials) had loss rates over 50%.

Concentrated Stock Position

When do such catastrophic declines happen? The next chart shows the percentage of companies at any given time experiencing a catastrophic loss. These loss rates tend to rise during recessions and market corrections, but there’s a steady pace of distress even during economic expansions. I don’t think we should draw too many conclusions from the decline in loss rates in 2010-2013; they have been dampened by the longest and largest monetary experiment in the history of the Federal Reserve, during which time the real cost of money has been negative for more than 5 years. There is also a natural tailing off at the end of the chart, given that there is less time for companies to fail.

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Concentrated Stock Position

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