Company A is fast-growing, high-tech, and widely regarded as one of America’s best corporations. Company B is slow-growing, low-tech, and not even the CEO’s mother would use the word “best” to describe it. Which company should you invest in?
If you guessed Company B, you’re right. “Staid, unattractive companies tend to return more to investors than glamorous companies,” says William Bernstein, author of The Investor’s Manifesto. “A good number of studies show this strange paradox to be true. And there are plenty of examples.”
As a case in point, he directs you to pre-millennium Microsoft. “It was the company to buy in 1999,” says Bernstein. Everybody wanted to jump on that train. Unfortunately, the train never left the station. Microsoft (ticker MSFT) is now selling well-below what it was back then. Let’s compare hip, exciting MSFT to not-so-exciting Hormel (HRL), producer of canned lunchmeat. According to Morningstar Principia, MSFT underperformed HRL by 11 percent a year over the past decade.
In one study published in the Journal of Portfolio Management, researchers looked at the stock performance of companies ballyhooed over many years in Fortune magazine as “America’s Most Admired Companies.” Researchers found that compared to returns on stocks of not-so-admired companies, the admired companies’ stock performance fell way shy, with average annual returns more than 2 percentage points below that of the spurned companies.
Meir Statman, professor of finance at Santa Clara University and one of the authors of the study, says that the “good company/bad stock” phenomenon is not as bizarre as it seems. “Consider a shiny new Lexus. Now consider a used Toyota. The Lexus is perhaps the better car, but if it’s selling for $25,000 more than the Toyota,” says Statman, “is it necessarily the better buy?”
Clearly no. So it often is with most-admired companies, adds Statman. “The company may be stellar. But how much are you paying for a share in that company? Often the price-per-share of such companies, based on expectations of future sales and profits, is so incredibly high that the company, no matter how good, can’t keep pace.”
Remember how Facebook’s stock plummeted after it first appeared on the market at an astronomical price?
Bernstein half-jokingly speaks of his Investment Entertainment Pricing Theory (INEPT) to help explain why investors in Microsoft, Facebook, and Apple have been so disappointed with their stock picks. “It is much more entertaining to invest in a company like Apple than in a company like Federal Screw Works.” Because many investors seek (perhaps subconsciously) entertainment value, says Bernstein, it drives the price of stock in these companies to the point that, like Microsoft in 1999, the managers must perform miracles if investors are ever going to profit.
The bottom line is to not pick individual stocks in the hopes of beating the market. Invest in low-cost, broad-based index funds, such as Vanguard Total Market ETF (VTI). If you wish, says Statman, put some of your stocks (perhaps 20 percent of the total) into a fund such as the Vanguard Small-Cap Value ETF (VBR), which is essentially an index fund of “least admired” but more-likely-to-succeed company stocks.
Good Countries, Bad Stocks
Lately, many investors have gone from trying to pick individual stocks to picking funds that track the stock markets of individual countries. But research has shown the very same phenomenon that exists with individual company stocks—stocks in nations deemed “most admired” tend to lag. “Five or so years ago, China was the country investors were excited about, and pouring money into,” says Jay Ritter, professor of finance at the University of Florida. Mexico, however, was south of everyone’s radar. Sure enough, in the last five years, while China’s economy has exploded by 50 percent, and the economy of Mexico has languished, stocksin Chinese companies have lost money (average annual return of roughly 2.5 percent), while stocks in Mexican companies have done well (average annual return of nearly 7 percent). The reasons for the “good country/bad stock” paradox are the very same as the “good company/bad stock” phenomenon, says Ritter – prices shoot to stratospheric levels based on high expectations.