Investing isn’t a beauty contest

published 2 February 2015

It's always tempting to view media mentions of a stock as a contrarian indicator. Effusive praise for example, of Apple could be a sign that the peak is near. Harsh criticism Tesco might mean that it's time to buy. But is there any evidence that whether a company is admired or despised gives any insight into whether it's a good investment? Studies on this topic have come to very different conclusions.

In a 2006 paper*, Jeff Anderson and Gary Smith of Pomona College found that investing in Fortune magazine's list of the ten most-admired American companies would have been a winning strategy between 1983 and 2004. Anderson and Smith calculated that buying the top ten stocks each year, then selling the portfolio the following year to invest in the new top ten, would have delivered an average annualised return of 17.7% per year, versus 13% per year for the S&P 500. This was not due to the performance of a few hot stocks: 57% of all the stocks appearing in the top ten managed to beat the wider market over the next year.

So does this show that admired companies typically beat other ones? Not according to a 2010 paper** by Deniz Anginer of the University of Michigan and Meir Statman of Santa Clara University. They looked at the difference in returns from stocks that had high Fortune ratings ("admired companies") and low Fortune ratings ("spurned companies") from 1983 to 2007 and found that investing in the lower-rated stocks would have delivered better returns. Stocks with a high rating had an average annualised return of 16.27%, while those with a low rating returned 18.34%.

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The effect was even stronger when looking at the change in the company's reputation over the past year: those with falling ratings returned 18.76%, while those with improving ratings returned just 13.16%.

If that's not confusing enough, consider a 2007 paper*** by Tom Arnold, John Earl and David North of the University of Richmond, which took a slightly different slant. Instead of looking at the Fortune rankings, which are compiled from surveys of executives and analysts, they used magazine covers featuring a company, during the period from 1983 to 2002. Magazine covers tend to be driven by recent news, so many investors see them as a sentiment indicator.

The study classified these covers into positive, neutral and negative views and looked at returns over the next two years. They found that companies that were subjects of positive covers outperformed those that were subjects of negative covers, with an average cumulative two-year return of 37.63% versus 31.75%. However, those that were the subjects of neutral covers did better still, returning 43.37%.

Buy quality and value, not hype

At this point, it may look as if the results of each of these studies are just pure chance and there's no pattern to be found. That could be the case: these are relatively small samples tested in quite narrow circumstances (about two decades of US stock returns). So one wouldn't want to put too much weight on the findings. That said, there are reasons to think all of them could be correct at the same time, because they may be measuring different effects.

The companies featured in Anderson and Smith's analysis were mostly old, solid, highly profitable companies: the best of the best. There is quite a bit of evidence that higher-quality stocks outperform lower-quality ones, so it seems plausible that the outperformance of the most admired companies was a proxy for this quality effect.

Meanwhile, Anginer and Statman's paper doesn't show that the typical spurned company beat the typical admired one; the median return for admired companies was slightly higher (12.81% versus 12.52%). The overall outperformance for spurned companies came from a smaller proportion of stocks that did very well.

So it seems likely that their unpopular stocks contained two types of companies: those that are of poor quality or in declining industries, and those that are underperforming and out-offavour, but not intrinsically doomed. Investor psychology means that the latter are likely to be cheap, and it's well-established that cheap (or value) stocks outperform the market on average. In other words, spurned companies may well be a proxy for the value effect.

What about the magazine covers?

The study found that positive and negative covers signalled the end of a period of strong outperformance and strong underperformance respectively a turning point in a period of hype or panic. Conversely, it seems plausible that neutral covers were a case of "business as usual": good stocks that weren't being unduly hyped and continued to perform well.

All this suggests that investors are better off focusing on these underlying factors than whether a company is in favour at the moment. It makes sense to buy very good companies (at a fair price), but it also makes sense to buy cheap value stocks, since history suggests that both strategies are likely to outperform. But you should avoid heavily hyped companies and also avoid those that are being shunned for good reason. That's easier said than done, of course but it's a sounder approach than treating investment as a beauty contest.

*A great company can be a great investment, Jeff Anderson and Gary Smith, 2006

**Stocks of admired companies and spurned ones, Meir Statman and Deniz Anginer, 2010

*** Are cover stories effective contrarian indicators?, Tom Arnold, John Earl and David North, 2007

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.