SAFT ON WEALTH: Investing in the wretched

April 27, 2012

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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