The Trouble with Good Companies - Show 126

Tuesday, June 3, 2014 4,897 views

Apple, Microsoft, Exxon…Great companies valued in the billions upon billions. But do these titans of business make great investments? On the surface, the answer seems like it would be a resounding yes! But not so fast. If the source of returns is risk, how would investing in stable, stalwarts like Walmart and General Electric generate high returns? The simple answer is they likely won’t.

Finance Professors Meir Statman and Deniz Anginer wrote a 2010 study called "Stocks of Admired Companies and Spurned Ones." Their study was based on Fortune Magazine's annual list of "America's Most Admired Companies" from 1983 to 2007. They created an admired portfolio using Fortune’s top rated companies, and they created a spurned portfolio using the lowest rated companies. The admired portfolio returned a very respectable 13.81% over a 24 year, 9 month period. But the spurned portfolio beat the admired portfolio rather handily with a return of 16.12%.

The market perceives the spurned companies to be riskier, driving down stock prices so their expected returns are high enough to attract investors. In 2001, IFA looked at Fortune’s “Ten Most Admired Companies.” We broke them down as individual companies and as a tidy little portfolio. The study lost Dell as they went private, but the other nine provided mixed results. Not one company beat an all equity index portfolio, and the portfolio itself garnered about the same return as an IFA portfolio that contained 20% equities with 80% bonds. Needless to say, Fortune’s Admired portfolio needed far more risk to achieve a similar return.

So why do magazines like Fortune keep shoving stock picks down our throats? Well, Pro-index stories are boring. Nobel Laureate Paul Samuelson once said. “I tell people [investing] should be dull. It shouldn't be exciting. Investing should be more like watching paint dry or watching grass grow."

Learn more about the perils of stock picking in Step 3

 

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