Admired versus Shunned Companies
‘Tis the season for social chitchat . . . whether you have a gift for small talk or not. If the conversation turns to business or investments, inevitably you will hear some anecdote about “so & so” making a fortune on ________ (insert glamour stock of the day here . . . more on this below). Even though a healthy dose of skepticism is always warranted when you hear these types of stories, you might rather wish you had bought the said glamour stock.
But you might turn this around and ask your friends and family . . . or “so & so” . . . to weigh in on the following statement.
The better the company, the better the investment. True or false?
To amuse yourself, keep a running tally of the answers.
Does investing in better companies necessarily result in better investment returns? The fact that I am writing about this might lead you to assume that the answer to this is counterintuitive.
For the sake of argument, let’s divide companies into two general categories, grouping some under ‘Admired Companies’ and others under ‘Shunned Companies’ or those that have fallen out of favour. Anecdotally, examples of admired companies that are currently very much in the news are Barrick Gold, Potash Corporation (which recently went through a very public takeover attempt) and high flying technology stocks, like Apple and Google. What admired companies have in common are very strong earnings, great looking future prospects and, usually, share prices which have recently gone up a lot.
At the other end of the scale are the shunned companies, those that are out of favour. Amongst the characteristics of these companies are lower or perhaps even negative earnings; in addition, the share price has usually underperformed or perhaps even been negative. Anecdotally, examples of shunned companies include some Canadian life insurance companies, like Manulife Financial or Sun Life Financial, and US companies, like Bank of America and Xerox. I would describe Xerox as an old world company of bricks and mortar versus a new economy company like Google. So, keep in mind that common themes shared by the shunned companies are lower earnings, bad press and a poor performing stock price.
So back to the question we started with. Let’s put these admired and shunned companies on the following chart. To make things interesting, we will include some smaller admired and shunned companies as well.
If you were investing in a basket of companies and filled it with either admired companies or shunned companies, it would be pretty clear which basket held the better companies. But the most important question for investors is: Which of these baskets represents the better investment?
Fortunately, based on the criteria we have listed above, we are able to look at these various companies and go back in time to see what the difference would be if you made one investment choice over the other.
Using US data from 1927 – 2010, on chart #2 we see that one basket of companies has returned approximately just over 13% per year, one has returned 10.6% per year, and the other two have returned around 8% or less.
So, which basket do you think grew the most and delivered the 13% and 10% returns: the basket of admired companies or that of shunned companies?
Here’s the counterintuitive answer. It is actually the shunned companies, those companies that have lower earnings and less rosy prospects and all of the negative press associated with that.
Why is this the case? The reason boils down to one factor: price. The great news and rosy outlook of these admired companies is public and investors hear about it, so these high expectations are already built into the share prices. The result is that you pay a very high price for an admired company. The same process is at work in a negative way for the shunned companies, with low expectations being factored into the share prices, so you don’t pay high prices for a shunned company.
Let’s put this into perspective. Let’s assume you invested $100,000 in large shunned companies that would return 10.6% per year, and another $100,000 in really admired companies that would earn 7.6% per year. Over a 30 year time period (which is about the average investor’s time horizon), the growth of capital in the shunned companies would be twice as much as the admired companies ($2,054,000 vs. $900,000). A $100,000 investment in really shunned companies would grow to over $4,000,000: that’s four times higher than a similar investment made in the admired companies!
This leads to the following conclusion: investors who are trying to maximize their investment returns over time should have more exposure to shunned companies.
Investors trying to impress their friends or family can debate the merits of the admired companies.