Skewness in Returns

Paul Kedrosky has an interesting graphic on weblog post Skewness in Venture Capital Returns. It reminds me of when I used to look at junior oil and gas companies in Calgary. Arc Financial did and probably still does release a monthly publication on oil and gas companies. In its list of the top 40 companies, only the top quartile actually earned their cost of capital. And equally interesting--at least to me--is that very few companies managed to stay within the top quartile for a five year period. More often than not top quartile performers became mediocre performers after only a couple years.

Today's environment is much different from that of the mid-90s. Today oil and gas prices are much higher and royalty trusts are much more prevalent. Once a company discovers a pool or become of "critical size," one of the royalty trusts, with its lower cost of capital, typically pounces and gobbles up the junior. Or the junior itself decides to become a royalty trust and enjoy the subsequent pop in its stock price.

I suspect the top quartile in most businesses earn the outsized rewards while the rest suffer. In some businesses, the top quartile leads to a virtuous circle where the company attracts better talent with better opportunities and better pay. The better talent creates even more opportunities and on goes the cycle. With oil and gas companies, often their spike into the top quartile was connected to having found a good sized resource to exploit for a few years. Once the resources were depleted, the companies often had difficulty duplicating their earlier successes. Often they decided to spread their focus from a tight group of assets in the Western Canadian Sedimentary Basin (WCSB) to the far flung corners of the earth. More often than not, those diversification efforts fizzled.

I am curious if the top quartile venture capital companies are able to sustain their status over a long duration or if their status is the result of a few hit wonders?