When less popular stocks do better than admired peers
As in high school, maybe investment boils down to that mysterious thing: popularity.
Except in terms of putting money into stocks, it seems to be those eating lunch alone who do best in the end.
"We believe that most of the best-known market premiums and anomalies can be explained by an intuitive and naturally occurring (social or behavioral) phenomenon observed in countless settings: popularity," write Roger Ibbotson and Thomas Idzorek in a paper recently published in the Journal of Portfolio Management. (http://www.iijournals.com/doi/full/10.3905/jpm.2014.40.5.068#)
They show strong evidence that, over long periods, stocks which we can call less popular actually do better than those which, on a variety of measures, are just more admired or highly sought after. In one light, this is essentially another side of that old market truism which holds that when the fund manager or stockbroker is the most popular guest at a cocktail party then it just might be time to sell.
Ibbotson, of Yale, and Idzorek, of Morningstar Investment Management, argue that popularity can be that rare thing: a lens through which to make sense of the contrasting claims of both the efficient markets and behavioral approaches to explaining securities pricing.
Using stock market turnover as a marker of popularity, the authors find a strong correlation between both higher returns and lower volatility. Stocks in the lowest quartile of popularity had an annualized return of 15.51 percent between 1972-2013, as compared to just 8.27 percent for those in the top quartile.
If you further examine a ranking of stocks by popularity to look at how they do by volatility you find a general trend of less popular stocks outperforming higher ones in each of the four volatility quartiles.
They did similar studies to look at stocks by both popularity and beta, size and valuation and got what they called similar results.
"Measured by turnover, the more popular a stock, the less its return, the less popular a stock, the higher its return."
TALE OF TWO WORLD VIEWS
Economic theory holds that in a rational world (forgive me for laughing), the risk of a given investment ought to be strongly linked to its expected returns. That's just another way of saying that investors expect to be paid for holding riskier assets.
Except of course, as we all know from casual observation and study, it doesn't always quite work that way. While this generally holds true in asset classes (think stocks returning more than bonds) there are significant anomalies which investors have explored and puzzled over for decades.
That this is true doesn't in itself discredit the efficient market hypothesis, but rather shows that things other than risk drive asset returns within asset classes. The so-called low-beta anomaly, which holds that stocks with lower volatility on some measures do better than higher-volatility stocks, may simply reflect a preference for shares with embedded leverage among fund mangers who aren't allowed to use leverage themselves, according to a theory from Cliff Asness of AQR Capital.
Ibbotson and Idzorek think that popularity is in part a reflection that the underlying stocks have attributes that people want, such as liquidity, size or value.
Liquid stocks are easier to trade, big stocks allow investors to buy and sell in large size without moving the market too much, and shares trading at high valuations usually have great 'stories' and, significantly, no black marks against them.
But there can also be behavioral reasons that investors chase one stock and shun another, factors which might create irrational pricing. The revulsion investors feel when considering a stock which might go bankrupt, for example, may bring on a stronger reaction than the mathematical probability of loss. Conversely, a great-story stock, like Facebook, with a very high price, may bring with it warm feelings, not least the anticipation of getting rich if it keeps on shooting up, which make investors willing to pay too much.
Broadly speaking those aspects of popularity that are traits which are expected to be permanent, or long lasting, such as liquidity or volatility, are consistent with efficient markets.
Those things which are passing in nature, the popularity of Apple or Facebook, or stocks which are much in the news, are consistent with behavioral investment explanations.
The well liked, the familiar and the easy to access may have great qualities as companies and some advantages as investments, but it pays to look for companies with hidden depths. – Reuters
* James Saft is a Reuters columnist. The opinions expressed are his own
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