Look Down Before Looking Up – Part 1

In 1985, Warren Buffett made his television debut on PBS’s “Adam Smith’s Money World.” The first words he uttered during a humble seven-and-a-half-minute appearance were:

"The first rule of an investment is: Don’t lose. And the second rule of investment is: Don’t forget the first rule. And that’s all the rules there are."

While seemingly simple, Buffett’s rules are almost mathematically impossible. Nevertheless, the core message is clear: prioritize the downside and let the upside take care of itself. In other words, “look down, before you look up.”

The purpose of the 1% IRR Project is to deconstruct investing into first principles such that they can be reconstructed for better decision-making. 

To deconstruct the potential outcomes for a long-term investor, a good starting point is to look at the history of stock prices over a long period of time, ensuring consideration of various economic cycles.

Breaking into First Principles: Evaluating Historical Data

Looking Down: A Sobering Reality

Certain patterns emerge when analyzing the history of all U.S. stocks from 1926 – 2023 (Hendrik Besseminder, professor at Arizona State University, has done excellent research compiling and analyzing historical stock prices).

Focusing on the Negative Outcomes:

• Approximately 52% of all stocks had negative lifetime returns

• About 33% of all stocks lost more than 75% of their value. In other words, when stock prices fall, they fall hard

A similar study from JP Morgan analyzed the lifetime returns of all stocks in the Russell 3000 from 1980 to 2014 or until a firm was acquired, merged, or delisted.

Summary of the Negative Outcomes:

• Roughly 40% of all Russell 3000 stocks had negative absolute returns.

• Comparing stock prices against the Russell 3000 index, the median stock underperformed by an excess lifetime return of -54%.

• About 66% of stocks had negative excess returns vs. the index.

The difference between the studies is likely due to JP Morgan’s study (1) excluding micro-caps and (2) evaluating market data during a secular bull market.

Key Takeaways:

• Many stocks will fail. Statistically, when evaluating an investment, it’s a coin flip whether it will work.

• Markets go up but stocks go down. The data looks even bleaker when comparing against a market index since 2/3rd of stocks historically underperformed the market.

The Creative Destruction of Capitalism

The byproduct of a healthy capitalist system is that many companies will be destroyed. In Joseph Schumpeter’s classic work, “Capitalism, Socialism, and Democracy”, he made this poignant assertion about capitalism:

The opening up of new markets … and the organizational development … illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism [emphasis added].

The steady-state of a capitalist society is that the old will give way to the new. As new industries emerge, old ones decline or disappear entirely, driving economic evolution. This is an endless cycle.

Accelerating Creative Destruction

A 2016 study by Vijay Govindarajan of Dartmouth's Tuck School of Business analyzed 29,688 firms listed from 1960 through 2009.

The paper’s abstract tells the story:

Life is short. That’s never been more true for corporations today. An analysis of all 29,688 firms that listed from 1960 through 2009, divided into 10-year cohorts, reveals that newly listed firms in recent cohorts fail more frequently than did those in older ones. Creative destruction is accelerating because there is a fundamental shift in the American economy. The pre-1970 firms tended to be heavily invested in physical infrastructure, such as factories and inventories. Later cohorts have relied increasingly on intangible assets, such as databases, proprietary algorithms, and expert workers. This transformation is a double-edged sword. The good news is that newer firms are more nimble. The bad news for these firms is that their days are numbered. That is, unless they continuously innovate.

Corporate Survival

Key Takeaway:

• Corporate mortalities are accelerating.

• The weighting of companies built upon hard assets is declining while soft-asset companies are rising.

• Soft asset companies generally have fewer barriers to entry, and therefore higher mortality rates.

1% IRR Improvement:

Understand the game that is being played.

• Recognize that a healthy capitalist system naturally destroys businesses.

• Acknowledge the accelerating pace of destruction.

• Realize that many of today’s companies will not be around in 5 years, less in 10 years, and even fewer in 20 years.

A mountain climbing analogy:

• If ~50% of climbers fall on a certain path, you will be cautious.

• Knowing that an increasing number of climbers are falling earlier in their journey, you will be even more vigilant.

In other words, you will look down before looking up.

Part 2 will explore “Looking up” or the state of winners.

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