Given the choice of 2 companies, one admired by the public and one despised, where should you invest your money? The answer may not be obvious.
A recent Opinion Piece on www.marketwatch.com by Mark Hulbert reminded me of a White Paper prepared on this subject in 2010. Prof. Deniz Anginer, University of Michigan and Prof. Meir Statman, Glenn Klimek Professor of Finance, Santa Clara University, pondered the question "Do stocks of admired companies yield admirable returns?" If so, "Are increases in admiration followed by high stock returns?"
Anginer and Statman looked at companies found on Fortune magazine's annual list of "America's Most Admired Companies" published during 1983-2007. The list of admired companies in 2007 included Walt Disney, UPS and Google, which also appear on 2019's list. These admired companies were compared to a list of spurned companies, with each list containing half of the companies rated by Fortune. The conclusion of the research is that those companies least prized by their peers outperformed the admired group by over 2% in annualized return. Further, those companies whose reputation was declining during the study far outperformed the companies whose reputation was improving. The excess return of the declining companies was a whopping 5.6%.
The conclusion of the study could be a head-scratcher if you don't read the entire paper to learn more of the details. The high returns attributable to the despised companies were heavily skewed by a handful of huge winners. Many stocks of the despised companies did not perform well relative to admired group.
So what lessons should the average investor take from this research? Here are a few main takeaways:
- Investors usually have great expectations for admired companies. As a result their stock is often being sold at a very high price relative to their earnings. It is not enough to identify great companies, you must identify great companies being sold at a great price.
- Diversification is still one of the greatest tools to reduce risk. Yes, a portfolio of despised companies outperformed the admired companies in the study, but only if you held all of the despised companies. If you tried to pick out only a few, the odds of succeeding become much lower.
- It is important to set aside your emotions when investing. If you were given the choice between 2 companies in which would you choose to invest--an innovative, exciting crowd favorite or a mature, reliable stalwart, which would you select? Our immediate reaction is to invest in the crowd favorite. That visceral reaction highlights the danger of following your heart instead of your head. The choice posed to you did not identify the risks involved or the purchase price. The correct answer is "there is not enough information to choose," yet your brain already leaped to a conclusion. When investing it is oftentimes better to choose the road less traveled.
For many successful investors these lessons will probably not come as a surprise. However, I regularly meet potential new clients whose portfolios are comprised of only a few admired companies. While they may get lucky and identify a future high flyer, they are limiting their odds of success. Instead, I prefer to tilt the odds in my favor. I may not win every time, but investing is a marathon, not a sprint. I want the best chance of success over the long run.