Excellent Company or Excellent Stock?

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Good companies do not necessarily make good investments. A portfolio of "unexcellent" companies (chosen on the basis of financial ratios) outperformed the S&P 500 by 12% per year from 1981 to 1985, whereas a portfolio of "excellent" companies outperformed the index by only 1% per year. Over the 1988 to 1992 period, again the "good" companies' financial ratios deteriorated while the "poor" companies' ratios improved. As investment portfolios, however, the good companies outperformed the S&P 500 over the period, producing a monthly alpha of 0.38%. The poor companies underperformed, producing a monthly alpha of -0.07%. There appears to be a tradeoff between growth and profitability versus valuation ratios. While good companies do not necessarily make good investments, the market appears to reward profitable companies selling at reasonable multiples.

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