Some people happily pay a premium for quality. If you think a product — like iPhones, designer bags, or shoes — is higher quality, it might be worth paying more. Sometimes you actually get more than your money’s worth. Other times, the premium is the cost of being associated with the logo.
It’s no different with stocks.
Investors pay a premium for stocks labeled “quality” or “excellent.” Sometimes, it’s worth it.
In 1987, Michelle Clayman tested the performance of so-called “excellent” companies based on fundamentals relayed in the book In Search of Excellence.
The book labeled 36 publicly traded companies as “excellent” based on specific fundamental criteria: asset growth, equity growth, return on capital, return on equity, return on sales, and price to book. Clayman looked at the performance of 29 companies (of the 36 still in existence) to see how well “excellence” performed. Over a five year period (1981-1985), an equal-weighted portfolio of the 29 “excellent” stocks beat the S&P 500 by 1.1% per year.
At the same time, she tested 39 “disaster” companies. These were the worst companies based on the same criteria. An equal-weighted portfolio of the “disaster” stocks beat the S&P 500 by 12.4% per year over the same five year period.
Here’s how Clayman explained the unexpected results:
Over time, company results have a tendency to regress to the mean as underlying economic forces attract new entrants to attractive markets and encourage participants to leave low-return businesses. Because of this tendency, companies that have been “good” performers in the past may prove to be inferior investments, while “poor” companies frequently provide superior investment returns in the future. The “good” companies underperform because the market overestimates their future growth and future return on equity and, as a result, accords the stocks overvalued price-to-book ratios; the converse is true of the “poor” companies.
Five years is a very short test window to prove a theory. So Barry Bannister stepped up to test Clayman’s theory over a longer time period. In 1990, he published the results of his study based on the period from 1977 to 1989. His results were consistent. His “Unexcellent” stocks beat the “Excellent” stocks and the S&P 500.
Bannister wasn’t done. He returned to Clayman’s theory in 2013, looking at the 41 year period from 1972 to 2013. Again, the results were consistent. The “Unexcellent” beat the “Excellent” and the S&P 500 over the period. $1,000 invested annually in the Unexcellent portfolio grew to $1,615,054. The same $1,000 annually in an Excellent portfolio only grew to $502, 124.
Bannister explained the results of the 2013 study:
We find that what constitutes “excellence” for managers is most often not the case for investors… While financial “excellence” is defined by Watermann and Peters is a laudable management achievement, we find that it tends to produce a high-priced stock with potential for downward mean reversion. It is our view that a more rewarding investment strategy over time is the purchase of a portfolio of equities in financially solvent companies whose abysmal growth record of late has washed the last glimmer of hope out of the stock price. As the “Un-Excellent” companies revert to the mean, their stock performance is anything but average.
Returns tend to break down when you pay too high of a price. Optimism is so priced into “excellent” companies, that there is no room for error should fundamentals decline. And the fundamentals of most companies eventually trend toward average because of competitive forces.
- Excellent companies experience periods of less than excellent returns due to mean reversion.
- Disaster or Unexcellent companies experience periods of stellar returns due to mean reversion.
- Mean reversion affects price and fundamentals like growth rates, return of capital, return on equity, return on sales, and price to book.
- The price paid for excellence and un-excellence absolutely matter to returns.
- Undervalued “disaster” stocks beat overvalued “excellent” stocks in the long run.
It was Ben Graham who said, “In the short run the market is a voting machine, but in the long run, it is a weighing machine.” The market is a popularity contest driven by short-term thinking. Short-term thinking would suggest that great companies will continue to do great and poor companies will continue to do poorly and nothing will change that.
The reality is far different. Poor companies may never become great or even good companies, but their fundamentals mean revert. The same happens to good (and most great) companies too. In the long run, the market reflects it in prices.
In Search of Excellence: The Investor’s Viewpoint
In Search of Excellence: A Portfolio Management Perspective
Revisiting “In Search of Excellence: A Portfolio Management Perspective”
Defying Reversion to the Mean
This post was originally published on May 2, 2018.