Great Companies Don't Make Great Investments

Remember Peter Lynch's advice about buying companies whose products you like? It turns out this advice is not as good as it sounds. Great companies don't make great investments. You may love Apple's iPad, but this doesn't mean Apple is a great stock to buy. In fact, the opposite is usually true. Distressed companies have earned higher returns than those of companies with lots of hype or goodwill at the time of purchase. Unfortunately, investors generally avoid investing in distressed companies, because it seems counterintuitive to buy perceived losers.

Finance Professors Meir Statman and Deniz Anginer wrote a 2010 study called "Stocks of Admired Companies and Spurned Ones."1 Their study was based on Fortune Magazine's annual list of "America's Most Admired Companies" from 1983 to 2007. Fortune's annual surveys ranked companies on eight attributes of reputation:

  • Quality of management
  • Quality of products or services
  • Innovativeness
  • Long-term investment value
  • Financial soundness
  • Ability to attract, develop and keep talented people
  • Responsibility to the community and the environment
  • Wise use of company assets

From these ratings, Statman and Anginer constructed two portfolios, each consisting of one half of the Fortune stocks. The "admired" portfolio (often referred to as growth stocks) contained the stocks with the highest Fortune ratings, and the "spurned" portfolio (often referred to as value stocks) contained the stocks with the lowest Fortune ratings. For example, the list of admired companies included The Walt Disney Company, UPS and Google. Spurned companies included Jet Blue, Bridgestone and Stanley Works.

The results of the study are of no surprise to value investors. "Stocks of admired companies had lower returns, on average, than stocks of spurned companies." Figure 3-5 shows the 16.12% annualized return of the spurned portfolio and the 13.81% annualized return of the admired portfolio over the 24-year, 9-month period.

Figure 3-5

Why have value stocks delivered higher returns to their investors? The market perceives value companies to be riskier, driving down stock prices so their expected returns are high enough to attract investors. That is difficult for most investors to grasp since they prefer to believe growth stocks are better investments than value stocks. After all, investors looking for a stock tip want to hear the name of the next Apple, not the next JCPenney. As you will see in Step 8, the data indicates that investors should be interested in great investments (value stocks), not just great companies (growth stocks).

    -1 Meir Statman and Deniz Anginer, "Stocks of Admired Companies and Spurned Ones," Santa Clara University Leavey School of Business, Research Paper No. 10-02 (2010).
Step 3Stock PickersMeir StatmanDeniz AnginerAdmiredSpurnedPeter LynchFortune Magazine