Are The Most Admired Companies The Most Worth Investing In?
So, you are choosing to invest on your own. Your first instinct when choosing which companies to invest in may be to pick those companies that have the most name-recognition and established track record. What you may not be aware of is that your instinct will consistently lead you astray, and that these widely-admired companies are most likely to fail.
Each year, Fortune magazine releases a list of its “Most Admired Companies”. This issue comes about every single year, and Fortune works strenuously to flex their prowess and insight. In an attempt to rationalize their list, they submit an annual survey to rank the companies they asses based on the following eight characteristics:
1. Quality of management
2. Quality of products and services
4. Longer term investment value
5. Financial soundness
6. Ability to attract, groom and hold onto talented people
7. Responsibility to the community and the environment
8. Wise use of company assets
While these qualities are crucial in any successful business and are certain to be found in the most admired companies, some of these qualities are extremely subjective. There is no tangible way to be able to accurately predict longer term investment value, or, to judge wise use of company assets in a truly objective manner. Furthermore, if a company fails in just one of these categories, it no longer can be considered “admired”. Rather, the company in question is considered as spurned.
When comparing companies that are most admired and most despised, there is a line drawn between investing based on perception and investing based on value. According to a study performed on 23 successive annual Fortune magazine’s “America’s Most Admired Companies” lists, it was found that the companies which were most admired were those that yielded lower returns compared to the spurned companies on these lists—a supposedly completely unexpected result.
With this insight, you might want to second guess investing in a stock just because you think it is a good company. The same study found that passing judgement and distinguishing between good and bad is immediate and automatic—not based on reason or logic. Consequently, the subjectivity of the survey components, as well as personal bias are what shape the most admired company list. The same applies to stock picking. Deciding whether a stock is good or bad is an emotional process and one that is easily influenced based on perception. In turn, investors in stocks of admired companies reap rewards in the form of future returns as well as the idea of goodness that the company allegedly has (which the investor will later pay for); however, those who invest in despised companies receive rewards in the forms of returns only. This form of cognitive bias is what shifts individuals towards favoring the companies that are “admired”, even though they are not proven to have higher industry-adjusted returns than those labeled as “despised”. Your perception of an admired or spurned company is what is leading you astray.
You may be wondering, what drives the difference in returns between these two categories of stocks? What is causing such a disparity in returns?
Stocks which are habitually distinguished as up-and-comers, or, which are praised constantly in periodicals like “Fortune Magazine” are found to be large-cap stocks; however, based on Professor Fama and Professor French, two award-winning academics, small-cap value stocks (which largely fit into the “spurned” category) offer higher returns over long periods of time compared to glorified large-cap growth stocks. Thus, spurned and despised stocks are empirically and academically proven to be those which habitually succeed in the long-run. Moreover, if a company falls short in several categories, the company automatically has a chance of outperforming admired companies due to its likelihood to be part of the 3-factor Fama/French model which specifically notes that small companies outperform large ones, value companies outperform growth companies, and that investors receive greater returns based on the equity risk premium.
Another reason why these supposedly despised stocks do so well is because they are the epitome of true value investing. In falling short of the required categories to be “admired”, the company would be marked as inferior. This inferiority opens up the company to the opportunity of value investing—a reason to perform better than those companies that were admired. This brings to light the importance of value investing vis-a-vis the drawbacks of stock picking based on reputation and whim alone. Thus, the only way to escape the trap of market noise and falling victim to poor stock picks is ultimately tilting a portfolio towards value and small stocks and investing systematically—without allowing emotion and hype to blur and deceive your judgement. While the guidelines for admired companies appear to be a good investment strategy, in fact, they are leading you in the opposite direction.
These findings really beg the following question: If stock picking is such a fruitless endeavor, why do magazines like Fortune keep selling this elusive dream? The answer is very simple: Evidence-based low cost index fund stories don’t sell magazines! No big fund house would take out full-page advertisements that says “Don’t hire us – just listen to the academics and invest in index funds and relax.” Nevertheless, this is a very poor reason to perpetuate the myth that financial journalists can pick the exact stocks which will lead to riches. In fact, by taking a serious look at the data, the best way to lose a fortune is to follow Fortune Magazine’s most admired company advice.