The Price of Excellence

Jon writes on his blog that 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 from stocks. Investors pay a premium for stocks labelled “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 labelled 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. At the same time, she tested 39 “disaster” companies. These were the worst companies based on the same criteria. Over a five year period, the disaster companies beat the excellent companies handily! This result was repeated over studies conducted by Barry Banister over a longer period of time.

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.

Banister concluded that while financial “excellence” is a laudable management achievement, he found that it tends to produce a high-priced stock with the potential for downward mean reversion. It is his 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.

Jon concludes that 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.