The “Dash For Trash” Investment Style

“You never get fired for buying IBM” was an old saying (very old…) among corporate IT managers. Back when the world ran on mainframes, many companies would just plunk down their cash on the latest and greatest from Big Blue. Their machines worked, the service was good, and information technology was basically a back office function anyway. No need to go out on a limb…

Many investors – of all stripes, it must be said – tend to follow the same approach when looking at single stock ideas. A high quality company should yield high quality returns. Or, one hopes, at least not embarrassingly low performance. We can almost hear a junior hedge fund analyst thinking about recommending Apple 6 months ago: “No one gets fired for recommending THAT name!”

A recent CFA Institute paper from no less an author than Roger Ibbotson, with help from some Morningstar quants, basically says this idea is all wrong.Strong companies with great reputations and defensible competitive advantages underperform their weaker peers according to their analysis.

There are several links at the end of this section so you can read the entire paper, a Morningstar summary, and a Barron’s article but here are their key results for how various measures of “quality” filter through to stock returns:

  • Company brand: stocks of companies with corporate brands in the highest quintile (as measured by an independent consultancy) underperform their less well-regarded peers in the lowest quintile by 6.08 percentage points annually.
  • Company reputation: the highest quintile of companies (as with the prior point, measured by an independent polling group) underperformed the lowest quintile by 5.59 percentage points annually.
  • Competitive advantage: the top 20% of companies measured by Morningstar’s “Moat Rating” underperformed the lowest 20% by 4.25 percentage points annually.

The bottom line here comes down to the old Wall Street research analyst interview question: “In one word, what’s the difference between a great company and a great stock?” The answer is “valuation”. The Ibbotson paper posits that great companies tend to be overvalued precisely because they are great companies. The trouble is that everyone knows that, and the stock ends up overvalued.

The lesson – as Apple shareholders have recently learned – is that popularity is not an investment edge. For that, one needs to look at the bottom of the quality pile. Not the top.

Sources:

Entire paper (+140 pages): https://www.cfainstitute.org/-/media/documents/book/rf-publication/2018/popularity-bridge-between-classical-and-behavioral-finance.ashx?mod=article_inline

Morningstar summary (short, good read and free): https://www.morningstar.com/articles/906550/do-more-popular-stocks-have-lower-returns.html?mod=article_inline

Barron’s article: https://www.barrons.com/articles/brand-value-versus-stock-performance-51546034972?mod=article_signInButton