Andrew Page |
The long term performance of share markets is truly remarkable; a fact that is easily demonstrated by looking at a chart of any major market index. Despite regular and often severe effects such as wars, recessions, bubbles and crashes, the major industrialised markets have always recovered and gone on to carve out bigger and better gains. Over the long term, the share market has always outperformed all other asset classes, period.
As such, the merits of long term investing seem self evident. A patient investor, it seems, need do nothing more complicated than buy and hold a diversified portfolio of blue chip stocks. And in essence, that is something that this author has long argued.
However, there is seemingly a flaw in this reasoning; one that deserves further investigation. That is, the long term performance of indices cannot be used to validate a long term buy and hold strategy because indices are regularly adjusted: stocks on the decline are dropped, while stocks on the rise are incorporated. This means that the major market indices only ever measure and track the biggest and best companies, with poor performers regularly being replaced by more attractive alternatives.
The classic example which is most often quoted is the Dow Jones Industrial Average. Formed in 1896, it was initially comprised of just 12 stocks, of which only one, General Electric, remains. Excluding GE, an investment in any of these stocks would (according to popular belief) have resulted in a total loss – despite the fact that all of these companies were considered solid blue chip stocks, and despite the fact that they were held for the long term. You will hear many variations of this seemingly solid argument, but there is much more to the story.
For starters, the premise that stocks no longer present in the Dow went bust, and created a loss for investors, is simply untrue. In all but two cases, these companies were either taken over or merged with another company. The new entities all went on to produce excellent returns for investors. Those stocks that did eventually fail, U.S. Leather and Distilling & Cattle Feeding, did so after many decades (56 and 111 years later respectively), during which the dividends alone more than repaid investors purchase price. That is, investors in these stocks still came out well ahead despite the eventual failure of the companies.
| Original Dow components |
History |
| American Cotton Oil |
Acquired by Unilever (NYSE: UL). Market Cap $17 billion |
| American Sugar |
Became Amstar in 1970 and went private in 1984. Changed its name in 1991 to Domino Foods Inc. |
| American Tobacco |
Separated into several other companies in 1911 due to antitrust action. One of the main companies formed was the American Tobacco company, which went onto dominate the industry, and ultimately become Fortune Brands, which is still listed today(NYSE: FO). Market Cap $5.6 billion. |
| Chicago Gas |
Became People's Gas Light and Coke Co. in 1897, and then Peoples Energy Corp in 1980, a utility holding company. This was in turn acquired by WPS Resources and changed its name to Integrys Energy Group in 2006 (TEG). It has a market cap of approx $4.1 billion. |
| Distilling & Cattle Feeding |
Became Millennium Chemicals, part of Lyondell Basell, finally delisted from the NYSE in December, 2007 |
| General Electric |
Still listed. Market Cap $142 billion |
| Laclede Gas |
Still trading, removed from Dow in 1899. Current market cap $750 million |
| National Lead |
Became NL Industries in 1971, removed from Dow in 1916. Current market Cap $400 million |
| North American |
Became Union Electric Co (UEP) in 1956. Merged with Cipsco in 1998 to form Ameren Corp (AEE). Market Cap $5 billion |
| Tennessee Coal and Iron |
Acquired by U.S. Steel (NYSE: X) in 1907. Current Market Cap $4.9 billion |
| U.S. Leather pfd. |
Dissolved in 1952, paying shareholders $1.50, plus stock in an Oil and Gas company, that later became worthless. |
| U.S. Rubber |
Became Uniroyal in 1961, which was ultimately bought by Michelin in 1990. Market value of €13 billion |
Source: “Stocks for the Long Run” By Jeremy J. Siegel; Wikipedia.
Although I haven’t done the analysis, it’s a fair assumption that the returns from the initial 12 Dow components would have diverged away from that of the underlying index over time, revealing an overall underperformance. The point though is that these investments would have nonetheless provided investors with very attractive returns, and significant divergence would have been observed only after many years. When dealing with the investment time frames that are practically achievable for even the most diehard long term investor, the eventual divergence with index returns is insufficient to label the long term buy and hold approach invalid.
In Australia, we have seen around 59 companies drop out of the S&P ASX200 index since 2007. This is no small number and again warrants further investigation. If you investigate each of these, you will see that half of these were due to mergers or name changes, 35% are still listed and trading today, and only 9 stocks actually went into liquidation. So in effect only a small minority of stocks that dropped from the index resulted in a total loss for shareholders.
The other point to make is that the largest and best capitailised stocks in the ASX 200 still remain. The only ones to be removed from this list in recent times include stocks like News Corp, Coles Group, & St George Bank, all of which dropped out of the index due to mergers or structural changes.
Finally, let me emphasise that I am not advocating that investors should hold onto stocks regardless of the circumstances. Certainly, one should seriously consider selling out of any holding if there has been a substantial and fundamental change to the outlook of a business. The bottom line is that although index performance will be favourably skewed by the ongoing revision of its constituents, it is nonetheless a reasonable benchmark for market performance. After all, long term investors will themselves divest out of underperformers, and make new investments in up and coming stocks.
Make the markets work for you
Andrew Page
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