SAFT ON WEALTH: Investing in the wretched
By James Saft
April 27 (Reuters) - At a time when one super-stock, Apple, is driving returns and portfolio construction, it is important to remember that there is usually more to be gained from the widely derided than from the universally loved.
Choosing stocks like Apple, which makes great products and has the glow of success about it, is an easy and comfortable choice. Investors feel they are affiliating with something successful, and they get that blast of pleasurable chemicals to the brain every time they see a positive story in the press or a surge in share price.
That success comes with a price tag. A review of the literature shows that portfolios with stocks in widely admired companies usually underperform baskets of stocks with companies nobody much likes.
A 2010 study by Meir Statman, a professor at Santa Clara University, and Deniz Anginer, a World Bank economist, found sustained outperformance from what they called 'spurned' companies.
The study used the annual survey of analysts and executives, conducted by Fortune Magazine, of the most and least admired U.S. companies as a benchmark. They found that over a 24-year period you'd actually be better off holding stocks of the least admired companies.
"We studied Fortune Magazine's annual list of 'America's Most Admired Companies' to find that stocks of admired companies had lower returns, on average, than stocks of spurned companies over the period April 1983-December 2007. Moreover, we find that increases in admiration were followed, on average, by lower returns," Anginer and Statman wrote in the study, published in The Journal of Portfolio Management.
Think about it: not only are you better off with, for lack of a more polite term, dog stocks, you had better monitor your portfolio for companies which are becoming admired with an eye to perhaps lightening your exposure.
The annualized return between April 1982 and December 2007 of the un-loved portfolio was 18.34 percent, easily beating the admired stocks' return of 16.27 percent. That sort of performance difference, over that sustained a period, is very significant; to be able to generate it simply by buying what others don't love is amazing.
FEELING GOOD VERSUS MAKING MONEY
The question you have to ask yourself: do you want to make money or do you want to feel good? Owning highly regarded stocks is a way for people to affiliate with success, just as people buy more Yankees caps when they are in first place. People like success and tend to be overly simplistic about it, feeling that it is a hard-wired trait rather than the result of the interplay between hard work, opportunity and - crucially for investors - valuation.
Statman did further work in 2011 and concluded that the difference in performance between hot and not-hot stocks was not, as many assert, tied to company characteristics - such as market capitalization or market-to-book ratios - but rather to t he fact that positive sentiment by investors who then make unrealistic assumptions about future returns and risks.
Human beings love to take the immediate past and then discount it into the indefinite future, assuming that a track record can in some way be a guarantee - irrespective of what price you pay for that record. Investors pay for that magic glow of success, and they usually pay dearly.
None of this is to say that people are wrong about which companies are excellent; they often are right. The problem is that they get carried away in what they are willing to pay to affiliate with excellence.
One important note of caution: returns were highly dispersed, meaning that quite a few of the unloved companies were disliked for a very good reason. They were on the way down the drain. Since it can be extremely difficult to glean the winners from the losers, the best response is probably to be widely diversified within the category.
All of this demonstrates that investing, in many ways, is like trying to play three-dimensional chess. You have to do more than simply understand the reality of the marketplace - who has a good product, how demand will develop, how input costs may grow. You can do all of the securities and company analysis you want, but if you simply make your decisions on that evidence you ignore the source of perhaps your biggest risk and opportunity: the other investors who set valuations. Other investors are going to do any number of things - fall in love with Apple, fall out of love with financials - that set the price at which you can buy exposure to those companies and industries.
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