A Great Company Can Be a Great Investment

Abstract

A classic investment mistake is to confuse a great company with a great investment. It is a mistake because a company’s well-known virtues are presumably already factored into the price of the company’s stock. This study tested this “mistake” by looking at the stock performance of the companies identified each year byFortune magazine as the most admired companies in the United States for 1983 through 2004. Surprisingly, a portfolio of these stocks outperformed the market by a substantial and statistically significant margin, which contradicts the efficient market hypothesis.

When we buy groceries, clothing, or a television set, we ask not only whether the food is good, the clothing attractive, and the television well built, we also ask how much an item costs. Is it worth the price? When we buy stock, we should ask the same question—not whether it is issued by a good company, but whether the price is right. Is the stock worth the cost? A classic investment mistake is to confuse a great company with a great investment. It is considered a mistake because a company’s well-known virtues are presumably already factored into the price of the company’s stock.

This study tested this “mistake” by looking at the stock performance of the companies identified each year by Fortune magazine as the most admired companies in the United States. We used the CRSP database to obtain the daily returns on every publicly traded top-10 company for each year from 1983 through 2004 beginning on that year’sFortune publication date. The strategy was to invest an equal dollar amount in each of the most admired stocks each year. In various calculations, the trading day was the publication date or 5, 10, 15, or 20 market days after the publication date. The comparison portfolio was fully invested in the S&P 500 Index for the entire 22 years. TheFortune strategy beat the S&P 500 by a margin that is both substantial and statistically persuasive.

From this comparison, we concluded that this observed difference in returns is unlikely to represent some sort of risk premium, because the companies selected as America’s most admired are large and financially sound and their stocks are unlikely to be viewed by investors as riskier than average. To investigate this conclusion formally, we estimated the Fama–French three-factor model augmented by a momentum factor. We found that the success of the Fortune portfolio does not appear to be attributable to the effects of market, size, value, or momentum.

We also analyzed the levels of wealth for the Fortune portfolio and the S&P 500 portfolio at 250-day intervals over a period encompassing the selection year and four subsequent years. TheFortune portfolios achieved, on average, a 16.51 percent increase in value, whereas the S&P 500 showed an average increase of only 10.27 percent.

The portfolio of Fortune’s most admired companies outperformed an S&P 500 portfolio, whether the stocks were purchased on the publication date or 5, 10, 15, or 20 trading days later. This result is a clear challenge to the efficient market hypothesis, becauseFortune’s picks are readily available public information. We have no compelling explanation for this anomaly. Perhaps Peter Fisher’s conclusion in Common Stocks and Uncommon Profits was right: The way to beat the market is to focus on scuttlebutt—those intangibles that do not show up in a company’s balance sheets. Fortune’s list of the most admired companies is the ultimate scuttlebutt.

Notes

¹ See http://money.cnn.com/magazines/fortune.

² Earlier surveys were based on similar criteria.

³ Factor descriptions and portfolios are from Fama and French (1993) and Kenneth French’s website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.

⁴ See previous note. We retrieved data on 20 September 2005.