Finding the next Amazon

In a recent post, I mentioned the research of Henrik Bessembinder who investigates the extreme outliers in the US stock market, i.e. the 200 best and worst stocks by 10-year performance. Obviously, we all would love to find the next Amazon before it becomes the next Amazon, but we all know that this is nigh impossible. Or is it?

Bessembinder concludes his series of papers on extreme stock performers with an analysis of typical characteristics that future top performers have. Looking at the best 200 and worst 200 stocks by decade should at least give us some hints at what to look for. 

For the future top performers, Bessembinder finds that these companies should invest in the future and come out of a difficult period with lots of drawdowns. Top performing companies in a decade have:

  • Invested more in R&D in the previous decade to fuel future growth (R&D investments to total assets of 4.8% for top firms vs. 2.8% for the average firm).

  • Experienced much larger drawdowns in the previous decade than the average firm (81% vs. 70%)

Additionally, the future top performers tended to be younger companies with lots of growth possibilities. In other words, they were growth companies with a shaky past that had to learn their lessons from past failures and disappointments and invested heavily in research and development to create a superior product or service.

Meanwhile, the worst 200 stocks have had some different characteristics:

  • They were already unprofitable in the previous decade with a much lower income to asset ratio than the average firm (-10.1% vs. 1.1% for the average firm)

  • They had higher growth of intangible and other non-traditional assets on their balance sheet (19.6% in the prior decade vs. 8.6% for the average firm)

  • They were more leveraged at the beginning of the decade (debt-to-asset ratio of 58% vs. 50% for the average company)

  • They had already issued a lot of new equity to investors in the prior decade (new equity issuance to assets of 26% vs. 9% for the average firm)

In other words, the worst stocks were overleveraged, haven’t been profitable in a long time, and had lots of dubious assets on their balance sheet such as goodwill and intangible assets that are vulnerable to accounting restatements.

Sounds easy, doesn’t it?

The problem just is that the Bessembinder also notes that the characteristics he investigated only explained about 2% of the cross-section of returns over the subsequent decade. 98% of the differences in returns remained unexplained. And that means that while the criteria above can give you an indication of which company will do well in the long run, they are by no means a sure thing. Other factors and sheer luck will still play an important role in any company that wants to become the next Amazon.