Good companies often make bad investments, study shows
- Securities with popular traits generate lower expected returns, while those with more unpopular ones receive higher expected returns, a new study finds.
- Researchers led by CFA Institute's Roger Ibbotson write that "any strategy or factor that is widely enough used will fail."
- Part of the problem is that brand and reputation information is public, meaning that great companies are often overvalued because they are great companies.
A good reputation, strong competitive advantage and popular brands may not only be hallmarks of any healthy Wall Street company, but also a sign of a poor investment idea, researchers at CFA Institute and Morningstar found.
Securities with popular, desirable traits generate lower expected returns, while those with more unpopular, undesirable traits receive higher expected returns, the study found. While that may sound counterintuitive to many investors, the stock market often assumes that any effect from a stellar reputation or large market capitalization has already occurred and is valued to reflect such characteristics.
"Assets are priced not only by their expected cash flows but also by the popularity of the other characteristics associated with the company or security," wrote Yale finance professor Roger Ibbotson and Morningstar researchers Thomas Idzorek, Paul Kaplan and James Xiong. "Despite these concerns, the market has rewarded value investing and other strategies ... that rely on buying what other investors are avoiding."
For instance, hordes of investors may find equity of larger companies more attractive than that of smaller companies because of risk and liquidity concerns. Some may be drawn to companies with excellent reputations or brands. But all of that information is public: Great companies are often overvalued simply because they are great companies.
The researchers studied a number of factors that make stocks popular, including perceived brand value, competitive advantage and reputation.
Of the 75 to 100 stocks studied based on brand value (as determined by third-party consultancy Interbrand), the those in the lowest 25 percent greatly outperform those stocks in the highest 25 percent between April 2000 and August 2017. The top companies by brand value in 2000 — including household names like Coca-Cola, Microsoft, IBM Intel, Nokia, GE and Ford — all fell in rating by 2017, with new leaders like Apple, Google and Amazon making the list.
Source: "Popularity: A Bridge between Classical and Behavioral Finance;" Ibbotson, Idzorek, Kaplan & Xiong.
Of the brands studied, those in the lowest brand value quartile over those years returned 13.5 percent annually versus 7.3 percent for the top 25 percent of brands (with monthly rebalancing back to equal weights).
The researchers found similar results based on competitive advantage, or "economic moat," which estimates a company's advantages based on intangible assets, cost cutting and networking effects.
Starting in July 2002, the researchers placed each stock in Morningstar's universe of 1,039 with moat ratings. Noting that many investors prefer companies they consider to exhibit strong competitive advantage, the researchers found that these stocks tend to be some of the most popular.
Despite that popularity, they found that the companies with zero- or near-zero competitive moat produced the "most superior" mean returns, albeit with more risk.
"Competitive sustainable advantage, brand power, and company reputation should already be baked into the price in a rationally efficient market and, therefore, should not be important to a rational investor who only cares about risk and return," Ibbotson and his colleagues wrote.
"Assuming that a powerful brand, a sustainable competitive advantage, and a good reputation are characteristics that investors like or admire, from the popularity perspective, some investors (the willing or unknowing losers) are simply willing to give up some level of return or overpay for a characteristic they like," they added.
The researchers also tested stock returns based on popular opinion, or how members of the general public rank U.S. companies with the best and worst reputations. Again, stocks with the lowest reputation rankings (i.e., least popular) outperformed those ranked higher, with statistically significant returns.
Of the companies studied, those that ranked in the bottom quartile of reputation between 2000 and 2017 returned a mean of 14 percent versus a mean return of 8.4 percent for the companies in the top reputation quartile.
"Investing in unpopular assets is hard. First, they are typically unpopular for a reason. Mounting losses instead of bountiful profits, declining market share or a shrinking market for one's product, an unusual loading of debt, and other characteristics that drive investors away are often indicators of continued poor performance rather than of what one value manager optimistically calls 'troubles that are temporary,'" the researchers concluded. "Any strategy or factor that is widely enough used will fail."