By Mark Hulbert, MarketWatch
New Line Cinema/Courtesy Everett Collection
Stocks are often bought because of the company’s reputation rather than its investment potential — and investors frequently pay a high price for making this error.
Fortune magazine’s recently released annual ranking of the most admired companies offers a good example. To state what should be obvious but all too often is overlooked, an admired company’s stock doesn’t always perform in an admirable fashion.
For instance, the company that was at the top of Fortune’s ranking one year ago: Apple /zigman2/quotes/202934861/composite AAPL -0.15% . Over the past 12 months through Feb. 1, the company’s stock has gained just 0.9% after adding back dividends. This year, Apple once again is at the top of Fortune’s ranking.
To be sure, Apple’s experience over the last year is only one data point. But it is consistent with the conclusions of an academic study a number of years ago by Deniz Anginer, a financial economist in the Development Research Group at the World Bank, and Meir Statman, a finance professor at Santa Clara University. The researchers analyzed the companies that Fortune over a nearly 25-year period through 2007 identified as most admired, comparing their stocks’ returns with those of the most despised companies in Fortune’s ranking.
The researchers found that a portfolio containing the despised company stocks outperformed a portfolio of the most admired companies’ stocks by almost two percentage points per year. Even more revealing: The researchers found that increases in admiration were followed by lower returns, on average. (See accompanying chart.)
The key to understanding this otherwise counter-intuitive result: a stock’s performance is not a function of how good its underlying company may be in any absolute sense. Its return will instead be a function of how the company does relative to investor expectations.
Investors have great expectations for a company that is already among the most-admired.
Investors have great expectations for a company that is already among the most-admired. Their expectations create a high hurdle that the company will have difficulty clearing. In contrast, investors expect little from a company that is already despised, making it relatively easy for such companies to beat expectations.
Anginer and Statman caution that care must be exercised when trying to profit from the conclusions reached in their study. That’s because they found that many of the despised companies’ stocks performed quite poorly, and that the impressive average return of the Despised Company portfolio derived from a relatively small number of huge winners. It therefore would be imprudent to pick just one or two despised company stocks in hopes of performing well.
Diversification therefore is key. One approach is to construct a portfolio of despised stocks that nevertheless are recommended by at least one top performing investment newsletter. We can get a good idea of which companies these might be by focusing on stocks with the worst trailing 12-month returns.
To construct the list below, I started with the 15 stocks in the S&P 500 /zigman2/quotes/210599714/realtime SPX -2.29% with the worst trailing 12-month returns. Then this list was narrowed down further by eliminating stocks not currently recommended for purchase by at least one of the top-performing newsletters tracked by my Hulbert Financial Digest. Just four stocks survived this winnowing process:
• Affiliated Managers Group /zigman2/quotes/209583132/composite AMG -5.00%
• Brighthouse Financial /zigman2/quotes/205830158/composite BHF -7.39%
• L Brands /zigman2/quotes/202062875/composite LB -3.86%
• Western Digital /zigman2/quotes/204213617/composite WDC -3.13%
Note carefully that you most likely will have to hold your nose when investing in such companies, especially compared to how good you’d probably feel investing in glamorous companies that are in the news for, among other things, being the most admired in the world. But the question we all need to ask is whether our goal in investing is feeling good, or making money.