Summary: Research by JPMorgan has outlined the danger of concentrated stock positions, finding that 40 per cent of companies studied had suffered a “catastrophic loss” in value. The study found that it made sense for a family to hold 100 per cent of its wealth in a single legacy stock only 6 per cent of the time.
Key take-out: Entrepreneurs need diversification. In most cases studied, it made sense to own no more than 30 per cent of the concentrated stock in question.
Key beneficiaries: General investors. Category: Shares.
Note to wealthy entrepreneurs: Concentrated stock positions are dangerous to your financial health.
That insight comes from a JPMorgan Asset Management study aptly titled “The Agony & The Ecstasy: The risks and rewards of a concentrated stock position.” In this study, Michael Cembalest, investment strategist for JPMorgan Asset Management, analysed the 13,000 companies in the Russell 3000 between 1980 and 2014. He found that roughly 40 per cent of the publicly-traded companies had suffered a “catastrophic loss” in value, defined as a 70 per cent decline or more from its peak value which never recovered more than 10 per cent of that original value.
That’s an important stat. Most entrepreneurs hang onto their legacy stock position, claiming that even through the hard times their original cost-basis was very low, so, despite short term blips, over the long run they still come out ahead. Cembalest recalls the roller-coaster history of Cisco Systems. The company peaked above $US80 in 2000, plummeted 86 per cent when the dot com bubble burst, and then in more recent years tripled from its lows hit in 2002. Cisco has returned 27 per cent since inception versus 8 per cent for the Russell 3000. In other words, it was a bumpy ride for long-term shareholders but they were rewarded for their patience.
Nice – but Cisco is an outlier. The median stock in the JPMorgan study underperformed the Russell 3000 by 54 per cent. In fact, two-thirds of the 13,000 companies couldn’t best the index. Break those numbers down further and some sectors fared even worse. The median utility and energy firms that came to market underperformed the Russell 3000 by more than 90 per cent.
That doesn’t make it easy to spot the optimal time to sell. The variability across companies – between star performers like Cisco and dogs like Kmart or Revlon – is simply too great. To underscore how unlikely it is that a company will repeat Cisco’s experience, Cembalest finds that based on volatility and his analysis of historical returns, it made sense for a family to hold 100 per cent of their wealth in a single legacy stock just 6 per cent of the time. To balance out this uncertainty, entrepreneurs need diversification. “In the majority of cases, it made sense to own no more than 30 per cent of the concentrated stock, and often none of it,” Cembalest writes.
Of course this is all a cold calculation on paper – in real life, an entrepreneur who doesn’t boldly hold his own stock is likely to send the wrong message to customers, employees and shareholders, and a hard charging entrepreneur usually wants to maintain a controlling interest in the firm he founded and built. There are other benefits to holding large positions in your own company that the analyst doesn’t address. But once the money is made, and hanging on to wealth becomes more important, the stark reality of Cembalest’s research suggests a different tack is needed. Don’t think your company’s stock is the next Cisco, when the facts suggest it’s most likely to end up like Kmart.
This article has been reproduced with permission from Barron’s.