Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and I'm joined by Tom Idzorek, Head of Investment Methodology for Morningstar.
Hello, Tom.
Tom Idzorek: Hi.
Wall: So we're here today to talk about popularity premium or unpopularity premium. You've written this fantastic paper with Roger Ibbotson. What's the theory behind it?
Idzorek: Well, I think there's a lot theory behind it and it's kind of hard to explain it, relatively quick. But so of course, I came from Ibbotson Associates, which is a firm that was acquired by Morningstar back in 2006. Ibbotson Associates was actually founded back in 1977. Roger did a lot of work on detailing the historical returns of stocks, bonds, bills and inflation. And what you see, of course, is that stocks are riskier than bonds and they've outperformed bonds, say long-term bonds are more risky than short-term bonds or cash and they've outperformed as well.
And so generally speaking, higher returns have come with higher risk and this is well documented. And then, I'd say this kind of view with the world is very – sinks very nicely with kind of modern portfolio theory, the CAPM, a rational view of how the markets should behave.
Wall: Absolutely. Emerging markets, small caps, we all think risk equals return.
Idzorek: Right. And of course, it's very visible in for a large number of asset classes that relationship holds. But then you can point out that there's a number of other anomalies whether it's the low vol, the low beta, value beats growth, I mean, there are these items that seem to produce a premium, but don't necessarily come with more risk. So over the years, Roger and I have been engaged in conversations about kind of why does that occur. And if I go back – it's almost 10 years now you know where we coined kind of the idea of popularity, but we hadn't really sown it up into a framework.
And so we were thinking was there – is there are a nice, simple, intuitive explanation that helps explain, not only those premiums that come with more risk, but what about those anomalies, those premiums that don't seem to be associated with greater risk. And it was through those conversations that we began to develop let's say the theory – the unifying theory of popularity. And so what's so attractive about it, is it does simultaneously do a good job of explaining both.
Wall: I mean, it's very similar to sort of the concept of contrarian investing, isn't it? It's the opposite of what you want in high school. You do not want popular assets, you want to look for the unpopular ones.
Idzorek: Well, of course in high school, I was hoping to be more popular than I was, but that wasn't the case. But, of course, anything that's popularity is often valued, let's say, by other students or in this case, we're talking about stocks that have the most desirable characteristics.
Well, the world does usually recognise that they already have the most desirable characteristics and as such, their prices have been usually been up. So if you think about risk is bad, so often people avoid risky assets and so that helps explain people want to avoid risk, but stocks seems to move up.
If you think about value versus growth for example, value stocks are the stocks that have been beaten down by the market, they're unpopular, they're out of favor with investors. Now, some portion of those value stocks will improve, let's say, whatever it is that they are doing and as they improve, they will move up in price. So they will – the market, we'll say, let's say, recognise that this is a deep value stock as it might be is improving their operations and with it the price increase occurs.
At the opposite of the spectrum, we are talking about growth items, they are usually the items that are most in the news, they are glamourous, they have very high price-to-earnings ratios, they have been bet up and some of them will fall. You can imply the same concept of on the things like size, so small cap tends to outperform large cap. By definition, I would argue that large cap is extremely popular if you think about each dollar or a pound or euro as a vote, large caps have a lot of votes behind them.
Small cap don't and some number of small caps will become large caps and some portion of large caps will become small caps. So there is just this natural re-ranking. Whether we are talking about movies or hairstyles or fashion, you can almost always rank things around the dimension of popularity and then there's this natural reordering or re-ranking that will occur.
Wall: How as an investor, do we sort out what is just cheap and what is unpopular?
Idzorek: Cheap and unpopular may often be the same thing and I would say that, one question is this, like – how do you avoid like a value trap, for example.
Wall: Absolutely, yeah.
Idzorek: That depends on how you kind of try to take advantage of this movement from the unpopular state to the popular state. So, for, let's say, a dimension of popularity, one is liquidity, so illiquid is less liked and highly liquid is dear or expensive, and so people bet that up. As a stock improves its characteristics, it will likely become more liquid and of course it will rise in value.
Wall: Tom, thank you very much.
Idzorek: Hey, thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
