Bessembinder’s 2020 paper describes how a handful of massive mega-cap compounders dominate market wealth. But those compounders began as small companies, meaning small-caps are the best breeding ground for future Bessembinder winners.
All the wealth belongs to the wealthy which may be how a sarcastic reader may sum up Hendrik Bessembinder’s Wealth Creation in the U.S. Public Stock Markets 1926 to 2019. Bessembinder’s analysis measured shareholder wealth creation (SWC) for 26,168 publicly-traded U.S. common stocks since 1926, benchmarked against one-month Treasury bill returns. His results argued 58% of individual stocks actually destroyed wealth over their lifetimes and that stock wealth was extremely concentrated. Just 83 firms (0.32% of the total) accounted for half of all cumulative wealth, and the top five firms (Apple, Microsoft, Exxon Mobil, Amazon and Alphabet) accounted for 12% of the total. The implication, as Bessembinder concluded, is that the chances of finding the true winners are vanishingly small and that investors would be better with passive indexing to guarantee they owned the winners.
But what if we just looked at small-caps? One of the key criticisms we have of Bessembinder’s paper is the inherent skew both in terms of size and time. Size-wise, the largest stocks always matter more than the smallest no matter how strong the performance. A $1T market cap stock rising 10% generates an additional $100B in stock market wealth while a $1B market cap small-cap would need to rise 10,000% to generate an equivalent value. And similar but no less important is a recency bias where the most recent winners start with much greater nominal size making their outperformance dominate returns in comparison to older historical winners. There is also the inherent confusion between total stock market wealth and the wealth that can be created by owning individual names. While concentration is a problem, it’s less of an issue for small-caps.
The “Bessembinder Effect”, as we’re calling it, suggests that because most stock market wealth is concentrated in a few names, investors are better off using passive index funds and that small-caps don’t matter. In reality, our analysis offers a strong case for small-cap for active management owing exactly to the Bessembinder Effect’s impact on large-cap investing. Mega-cap wealth concentration, particularly at today’s extremes, risks nominal and relative losses for large-cap investors, as the largest stocks today often cease to lead the markets over the next five to ten years. But that potential redistribution of wealth from the very top to other stocks can go a long way, particularly for small-caps. Small-caps are net beneficiaries of the Bessembinder Effect since within small-caps, returns are more evenly distributed, compounders are more plentiful and the chances to catch the next best wealth creators early are palpable.