Experts have long argued that popular stocks tend to be too expensive—but they may be wrong
Having neither the time nor the accounting skills to scrutinize balance sheets, I tend to leave stock picking to mutual fund managers or simply invest in index funds for my retirement savings. But way back in the 1990s I decided to open a cheap online trading account with National Discount Brokers (since bought by TD Ameritrade,) and deposited a tiny bit of “play money” to experiment with.
I’m not sure how much I’ve learned about the markets, but I’ve learned a lot about myself as an investor. I tend to like consumer stocks such as Apple and Dunkin’ Donuts, since they sell products that I personally use or consume. I am attracted to stocks that have a compelling story, a loyal and growing following, and big expansion plans. I also like media and entertainment companies, and tend to steer clear of companies in industries I don’t know much about, like airlines, energy, industrials, and health care. I’m not totally susceptible to fads and still care about “fundamentals” like price-to-earnings ratios, but my decisions are too-often based on what’s known to experts as “heuristics”—mental short cuts like extrapolating from anecdotal evidence, or sticking with the familiar.
In other words, I am attracted to the popular stocks, which means that I might be missing out on a lot of buying opportunities of more obscure, less glamorous companies that I’ve never heard of.
In a recent presentation at the Morningstar Institutional Conference, Roger Ibbotson of Yale School of Management and Zebra Capital called this tradeoff the “popularity premium,” which is the excess returns investors expect and demand from buying stocks that are unfamiliar and unexciting.
According to Ibbotson, it is the popularity of stocks that leads them to be priced higher relative to their less admired peers, an aspect of risk that is frequently ignored. (You can read more about his theory in this Journal of Portfolio Management article.) In his analysis of popular versus unpopular stocks, the least popular stocks outperformed the most popular stocks.
This would suggest that, for example, instead of flocking towards the cool crowd (Alibaba, say) I might have been wiser to buy that ball bearing company in Ohio that just completed a spin-off (Timken). “The stock that you’re going to be talking about this year at a cocktail party is not the same stock you’re going to be talking about next year,” says Ibbotson. “There is no such thing as a permanently popular stock.”
But what if, as some behavioral economists believe, the market is actually being dominated by investors who are drawn to justly well-known and admired stocks but not “fad” stocks that just happen to be the flavor of the week and lack genuine intrinsic value?
And further, what if, as C. Thomas Howard of the University of Denver and AthenaInvest proposed in his recent book Behavioral Portfolio Management, professional investors such as mutual fund managers recognize that tendency and wind up buying those same well-known and admired stocks as a result? After all, Howard explains, “funds must attract and retain emotional investors, which means catering to client emotions and taking on the features of the crowd. As the fund grows in size, it increasingly invests in those stocks favored by the crowd, since it is easier to attract and retain clients by investing in stocks to which clients are emotionally attached.”
If that’s true, then just as popularity can create inflated prices that will quickly be corrected by the market, it can also create market darlings whose popularity, while not necessarily invulnerable, certainly has some longer-term staying power. In other words, popularity in and of itself is not always a bad thing. The trick, of course, is knowing how long it might last, and a balance sheet won’t necessarily tell you that.