“Excellent” companies had a record of soaring asset and equity growth and lofty profitability, while “unexcellent” companies had an opposing history. “Excellent” companies were accorded much higher valuation ratios than “unexcellent” companies. Five years after being selected, the “excellent” companies beat the market by barely 1 % annually, with the mainstream of stocks underperforming the market, whilst “unexcellent” companies beat the market by about 12 % annually, with the majority beating the market. Tendencies exemplify companies that have been “good” performers previously may attest to be inferior investments, since the market overestimates their future financial outlook. The converse is true of “poor” companies.

Why this inclination? One idea is that investors tend to become overconfident about buying or owning a stock that has a history of past success and a strong reputation, and hence are willing to pay a premium for such stocks, cutting into future stock returns.

Alternatively, “unexcellent” companies tend to get sold by fund managers, even at depressed prices, because they don’t want investors to see their past mistakes listed among current holdings. Neither institutional nor individual investors particularly relish owning “bad” companies. “Excellent” companies also tend to be large companies that may attain a limit in size above which they have to dabble outside their core business to grow, or find that the government limits their ability to expand.

Another key concept is “reversion to the mean” which suggests that in the long run, things will average out. Economics suggests that if a company or industry is growing rapidly and enjoying above average profits, then new firms will enter the industry until profitability falls to merely average; conversely, weak companies or industries with low profitability will typically experience capacity reductions, moving profitability up towards average.

For Instance, if an investor chooses a basket of “high growth” stocks and “low growth” stocks, five years later the earnings growth rates of both baskets will be indistinguishably average, but the “low growth” stocks would have been bought at the better price.

Similarly, when an athlete makes the cover of Sports Illustrated, he or she will be “jinxed” and not perform up to expectations. There may be a rational justification for this; an athlete is likely to make a magazine cover after reaching a peak of performance and expectations. By the same token, when companies or their managers are featured on the covers of business magazines, and newspapers write odes to their “excellence”, it is quite possible that such companies have already reached their peaks.

I’m not signifying that investors should forego excellent companies; they just shouldn’t expect that companies renowned for their good traits will automatically breed supernatural returns. Instead, I think investors should contrast a company’s current reputation to realistic expectations of future performance, coupled with valuation analysis. This may assist to minimize the bumps and shocks that are certainly waiting for many companies, “excellent” or not, down the road.

<B>Nitish Benimadhu

Your comments are mostly welcomed:

[email protected]</B>