Why Most Stocks Fail
Hendrik Bessembinder’s studies have revealed how very difficult it is to identify long-term stock market winners. According to his study, 96% of stocks failed even to beat US treasury bills. Is this possible?
Yes. The explanation is that a free price and profit system, operating with unimpeded competition, tends to drive profits down, not up, and eventually drives profits earned on commodity businesses very close to zero. I discussed how this works in Economics in Three Lessons:
Profits are an integral part of any free price system. If people are free to set the prices for what they are selling, they will naturally try to set the price high enough to earn a profit. This actually works to [the buyer’s], not just the seller’s, advantage.
Some people believe that a profit margin (what the producer earns over and above cost) makes goods or services more expensive. Philosopher Ted Honderich expresses this viewpoint:
If there are two ways of [producing] some valuable thing, and the second way involves not only the costs of [producing] it . . . but also [unnecessary] profits of millions or billions of dollars or pounds, then . . . the second way is patently and tremendously less efficient.
Honderich could not be more wrong. The quest for profits in a competitive market increases supply. Increased supply in turn lowers, not raises prices. If profit is eliminated, prices will tend to rise, not fall. This is exactly what happened in France when government restricted the price of bread in order to make it more affordable. The result was that bread became much more expensive if it could be found at all.
The quest for profits also drives businesses to try to lower their costs—the prices they pay. The best way to lower business costs is to invest profits in equipment, facilities, or worker training. Businesses that fail to invest in order to lower their costs will soon find themselves losing out to competitors.
If a business succeeds in reducing its costs, this may increase profits, but usually not for long. Studies consistently show that over time the money saved by becoming more productive is used to increase worker pay or reduce consumer prices. Why? Because businesses have to compete for workers and customers and will lose them if they do not keep wages going up and consumer prices going down.
It is not necessary for workers even to be in short supply for this effect to be felt. No business can succeed if a competitor attracts away the best workers, and even one competitor is enough to take away customers with lower prices. Since workers are also consumers, rising wages with falling consumer prices is a formula for helping the average person.
If profits are not just temporarily high in an industry, but seem to be stuck for a long time at a high plateau, and no one seems to be manipulating or controlling prices by creating a monopoly with the backing of powerful government officials, it tells us that there is some economic problem to be overcome, some bottleneck interfering with commerce. High profits then signal opportunity for the entrepreneur who can overcome the bottleneck.
For example, wheat was historically very difficult to get from farmer to market without spoiling or being eaten by rats, which enabled the hauler to charge high prices and earn a large profit. This eventually led entrepreneurs to invest in rat proof containers and also in better transportation. The price of fish also fell dramatically as entrepreneurs invested in better ships and then refrigerated ships, thereby cutting out many middle merchants and seaports. From a free price system perspective, the temporarily high profit margins did their work. They attracted ingenuity and capital and the combination helped solve an economic problem.
This is good news for society and consumers but not for the pioneering businesses. After they have solved the problem, other firms will move in to compete and profits will be driven toward zero.
This in turn explains why Bessembinder’s otherwise surprising results about stock market history should not be surprising. Entrepreneurs may earn extraordinary profits by solving some recognized economic problem or by innovating some new product, but once the problem is solved or the new product has been accepted, other firms will move in to compete. Profits will be driven toward zero. In the case of small businesses, profitless firms may continue indefinitely, because the proprietor works there and draws a wage. It is not necessarily a higher wage than what he or she could earn from another job, but it is enough to live on.
WRITTEN BY:
HUNTER LEWIS | CHIEF INVESTMENT OFFICER
