Excellent Company or Excellent Stock?

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Excellent Company or Excellent Stock?

Andrew West | 2000.12.19

“Buy the stock – it’s a good company.” This oft-repeated platitude is one that’s very popular on Wall Street, but it’s also one that I’m sick of hearing it because it’s not necessarily a useful guide for investors.

A major study by Michelle Clayman, entitled “In Search of Excellence: The Investor’s Viewpoint,” was published in the May-June 1987 Financial Analysts Journal. In her study, Clayman tracked the stocks of the “excellent” companies mentioned in the best-selling book “In Search of Excellence”, comparing their performance against a portfolio of poor-performing “unexcellent” companies.

“Excellent” companies had a history of high asset and equity growth and high profitability, while “unexcellent” companies had a history of the opposite. “Excellent” companies were accorded much higher valuation ratios than “unexcellent” companies. Five years after being selected, the “excellent” companies beat the market by only about 1% per year, with the majority of stocks under performing the market, while “unexcellent” companies beat the market by about 12% per year, with the majority beating the market. Based on this, Clayman concluded that, while “companies that have been “good” performers in the past may prove to be inferior investments…because the market overestimates their future growth and future returns on equity…the converse is true of the “poor” companies.”

Researchers have theorized about why this may happen. One idea is that investors tend to become overconfident about buying or owning a stock that has a history of past success and a strong reputation, and therefore are willing to pay a premium for such stocks, cutting into future stock returns.

On the other hand, “unexcellent” companies tend to get sold by fund managers, even at depressed prices, because they don’t want investors to see their past mistakes listed among current holdings. Neither institutional nor individual investors particularly relish owning “bad” companies. “Excellent” companies also tend to be large companies, that may reach a limit in size above which they have to dabble outside their core business to grow, or find that the government limits their ability to expand (due to antitrust concerns).

Another key concept is “reversion to the mean” which suggests that in the long run, things will average out. Economics suggest that if a company or industry is growing rapidly and enjoying above-average profits, then new firms will enter the industry until profitability falls to merely average; conversely, weak companies or industries with low profitability will typically experience capacity reductions, moving profitability up towards average.

Confirming this impression, Robert Haugen, in his book “The New Finance” suggested that if an investor chooses a basket of “high growth” stocks and “low growth” stocks, five years later the earnings growth rates of both baskets will be indistinguishably average, but the “low growth” stocks would have been bought at the better price.

Many are familiar with the “Sports Illustrated Cover Jinx” which suggests that when an athlete makes the cover of Sports Illustrated, he or she will be “jinxed” and not perform up to expectations. There may be a rational explanation for this – an athlete is likely to make a magazine cover after reaching a peak of performance or expectations – but the very attainment of fame or fortune can also distract many athletes from their sports. By the same token, when companies or their managers are featured on the covers of business magazines, and newspapers write odes to their “excellence”, it is quite possible that such companies have already reached their peaks.

Thus far, the debate over investing in “excellence” has failed to reach a definitive conclusion, so these ideas should be considered only interesting hypotheses for ongoing research. Even advocates of stocks of “unexcellent” companies admit they can underperform for many years. For example, Michelle Clayman wrote a second article entitled “Excellence Revisited” that compared “good” and “bad” companies from 1988 to 1992. This time, she found that the “good” companies beat the “bad” ones by about 6% per year.

I’m not suggesting that investors should forego excellent companies – they just shouldn’t expect that companies well known for their good qualities will automatically generate above-average returns. Instead, I think investors should compare a company’s current reputation to realistic expectations of future performance, coupled with valuation analysis. This may help to minimize the bumps and shocks that are certainly waiting for many companies, “excellent” or not, down the road.

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