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In our society, many decisions are made on the basis of popularity.  We want to be around well-known and well-liked people, we usually decide which clothes to buy according to prevailing fashions, and we often choose music, movies or television shows based upon how popular they are.  In the world of investing, however, following popular opinion is not a good strategy.

For example, many academic studies have shown that buying “popular” stocks (the stocks of the most admired companies or the companies with the best growth prospects) actually results in lower investment returns, on average. This may seem counter-intuitive, but some brief reflection will demonstrate why this is the case. If a company has enjoyed a recent period of popularity, the stock of that company has probably become expensive.  That is, as the financial media touts the company’s growth prospects and Wall Street analysts herd together to praise the wisdom of the company’s managers, individual investors rush to buy the stock, often without considering the price they are paying. When enthusiastic investors buy a stock without regard to price, the price becomes excessive, expectations for the company become unrealistic, and the results eventually disappoint.

Instead of chasing the most popular stocks, the wisest investors do precisely the opposite: They invest in the stocks of unloved companies in industries that have recently been out of favor.  This strategy, known as “value investing,” was developed by legendary investor Benjamin Graham and his protégé, Warren Buffett.  Value investing has been around for many years, and it has resulted in far better returns than a strategy of buying popular “growth” companies. For example, the best-performing stock of the past 20 years was not a high-tech startup that grew to be a global technology giant, or an energy company that enjoyed spectacular growth due to explosive global demand for energy.  The best-performing stock of the past 20 years was Kansas City Southern, a railroad company whose stock rose 19,030% over the period.  Just in case you are thinking that the results of Kansas City Southern are a fluke, you should be aware that the second-best performer over the period, with a return of 14,330%, was Middleby, which makes ovens and restaurant equipment.

Investing based upon value rather than popularity also works across the market as a whole.  If we divide the market into popular (growth) stocks and unpopular (value) stocks, we see that the premium received from investing in value stocks is significant and persistent over time.  For example, over the past 30 years in the U.S., value stocks have outperformed growth stocks by over 1.3% per year.  The value premium is even stronger outside the U.S.: International value stocks have outperformed international growth stocks by over 2.9% per year over the past 30 years.  While a few percentage point difference in annual returns may seem small, over the course of an investing lifetime the compounding effects of that difference can have a dramatic effect on an investor’s overall wealth.

Value investing is not sexy, it may not be fun to tell your friends about, and it often requires you to buy companies that are being touted as underperformers in the popular press. Going against the consensus is an uncomfortable feeling, and many investors are seduced into overpaying for a popular investment instead of underpaying for an unpopular one.  Yet, unpopular stocks can be attractive investments precisely because few people are willing to buy them.  This causes their prices to be relatively low and their future expected returns to be relatively high.

If you are a do-it-yourself investor, you can gain access to a value investing strategy relatively easily and inexpensively by using index mutual funds or exchange traded funds (ETFs).  If you are working with an investment advisor, you should make sure that he or she has positioned your portfolio to benefit from the advantages of value investing.  If your advisor is emphasizing popularity instead of value, you are probably overpaying for your advice as well as for your investments.

 


This article has been contributed by

Frederick R. MacLean Jr., CFA, MBA,
CFP, the President and a Partner of
Heritage Investment Group.

 

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