Jason Zweig, financial columnist for The Wall Street Journal, is one of the truly “good guys” in the world of financial media (by which I mean that he looks out for the interests of investors by providing knowledge instead of the typical hype). If he writes it, it’s worth reading. Thus, I read with interest his recent column on why stock picking is a dying phenomenon.
Zweig began by noting: “There were 7,355 U.S. stocks in November 1997…. Nowadays, there are fewer than 3,600.” He added: “A close look at the data helps explain why stock pickers have been underperforming.”
He then explained: “Several factors explain the shrinking number of stocks … including the regulatory red tape that discourages smaller companies from going and staying public; the flood of venture-capital funding that enables young companies to stay private longer; and the rise of private-equity funds, whose buyouts take shares off the public market.”
Zweig, in part quoting Michael Mauboussin, investment strategist at Credit Suisse Group AG, writes: “For stock pickers, differentiating among the remaining choices is ‘an even harder game’ than it was when the market consisted of twice as many companies …. That’s because the surviving companies tend to be ‘fewer, bigger, older, more profitable and easier to analyze,’” thus “making stock picking much more competitive.”
Zweig then moved on to his second major point: “The evaporation of thousands of companies may have one enduring result … and it could catch many investors by surprise.”
Specifically, he writes that the historical outperformance of many investment factors, such as size and value, may “have been driven largely by the tiniest companies, exactly those that have disappeared from the market in droves.”
He warns: “Before concluding that small stocks or cheap ‘value’ stocks will outrace the market as impressively as they did in the past, you should pause to consider how they will perform without the tailwinds from thousands of tiny stocks that no longer exist.”
I received several requests from clients to comment on the article, so I’ll share my thoughts on it here as well.
To begin, I agree that the fewer the number of stocks available, the less opportunity there should be for stock pickers to generate alpha (outperform on risk-adjusted basis).
I also agree that, because the smallest companies are the ones disappearing, all else being equal, it’s logical to conclude the small-cap premium should shrink. Indeed, a virtually monotonic relationship has existed between returns and size, with returns increasing as you go from the first decile (the largest stocks) to the 10th (the smallest, or micro-cap, stocks).