In their new book, Popularity: A Bridge Between Classical and Behavioural Finance, Roger Ibbotson and three Morningstar investment researchers, Thomas Idzorek, CFA, Paul Kaplan, CFA, and James Xiong, CFA, propose a new asset pricing model, one they call the popularity asset pricing model. As their book title suggests, this new model is intended to connect classical finance and behavioural finance, and their research provides some fascinating insights into stock returns.
They define popularity in general terms as the “condition of being admired, sought after, well-known, and/ or accepted.” When it comes to investing, they note that popularity is comparable to investor preferences.
While investors obviously prefer higher returns, they don’t know what future returns will be. But different securities have different, observable characteristics, and investors may exhibit preferences for certain characteristics.
“Even with the same set of expected cash flows, investors may have more demand for one asset over another, which gives the preferred asset a higher current price and a lower expected return. An asset could be liked, or disliked, for rational or irrational reasons. In this way, popularity spans ideas from both classical and behavioural finance, thus providing a bridge between the two camps.”
Within their framework, size—as measured by market cap—is a dimension of popularity, as every dollar of market cap can be thought of as a “vote” for that stock. Other popularity factors in their framework include liquidity, taxes, and severe downside risk.
What Makes a Stock Popular?
In a traditional capital asset pricing model, the preferences of investors, as they seek or avoid these characteristics, can be considered rational from a risk and return perspective. But the authors also studied three popularity characteristics that have not been previously examined: brand value, competitive advantage, and company reputation.
Here they note that investor preferences for them might be considered irrational, as these factors “should already be baked into the price” of each stock. By creating portfolio groupings based on each of these factors, they studied how they correlate with returns.
Company Brand
To assess companies by brand, the authors used the “Best Annual Brands” report that has been published by Interbrand each year since 2000. Each report lists the 100 brands with the highest estimated “brand value,” based on a proprietary methodology that is used to estimate the net present value of a company’s earnings related to brand value.
As the authors note, in some cases, companies like Volkswagen Group have multiple brands, while some well-known brands are private companies – Ikea, for example, and were excluded from the study.
To assess the relationship between company brand and stock returns, they divided the firms into four groups, or quartiles, with the quartile 1 representing the highest brand values and quartile 4 representing the lowest, and measured the performance of both equal-weighted and market-cap-weighted portfolios from April 2000 through August 2017.
The brand rankings obviously change from year to year—Coca-Cola (KO) topped the list in 2000, while Apple (AAPL) ranked first in 2017— so the quartile groupings were updated annually, and acquisitions and mergers were accounted for.
The equal-weighted portfolios were rebalanced on a monthly basis. Investors would have paid a price for investing in companies with the highest brand values. From April 2000 through August 2017, with the equal-weighted portfolios, the quartile 1 stocks had a geometric mean return of just 5.87% for that period, while the lowest brand value stocks in quartile 4 produced a geometric mean return of 11.95%.
As the authors explain, the equal-weighted portfolios produced higher returns because of a rebalancing premium, yet the same general trend is observed with the market-cap-weighted portfolios, though in this case, quartile 1 outperformed quartile 2.
Competitive Advantage
To assess competitive advantage and returns, the authors turned to Morningstar’s economic moat rating. To recap, the moat rating reflects Morningstar analysts’ assessment of the sustainability of a company’s competitive advantages. It’s based on Warren Buffett’s idea that some companies possess moats that defend against excess returns being competed away. The analysts consider five moat sources — network effects, intangible assets, cost advantages, switching costs, and efficient scale.
If they believe a firm has the prospect of earning returns on capital above its cost of capital, and can sustain those excess returns for at least 10 years, it receives a narrow moat rating. If they believe a firm can sustain those excess returns for at least 20 years, it receives a wide moat rating.
The authors created three portfolios based on moat ratings, which were updated monthly, since moat ratings can change. While it may seem counterintuitive, as with company brand, the authors observed a negative correlation between moats and total returns.
From July 2002 through August 2017, for equal-weighted portfolios, the stocks of wide-moat firms had the lowest geometric return at 11.15%, while the stocks of no-moat firms produced a geometric mean return of 15.4%.
And the same trend holds true for market-cap-weighted portfolios. They point out one nuance here, however: While moats correlated with lower returns during up markets, during down markets “such as the 2008 financial crisis and the more minor downturns of 2011 and 2015, the greater the sustainable competitive advantage, the milder the downturn.”
Company Reputation
To measure company reputation, the authors used the Harris Poll reputation quotient. The poll has a nomination phase in which the general public is first asked to identify U.S. companies with the best and worst reputations, and then in a second phase, approximately 250 people are interviewed for 20 minutes and asked to rate firms based on 20 attributes. In 2000, Johnson & Johnson (JNJ) topped the list, while Amazon.com (AMZN) ranked first in 2017.
With the same approach used for creating the brand value portfolios, the authors created four portfolios based on quartiles, with quartile 1 stocks having the highest company reputation scores and quartile 4 stocks having the lowest. The trend among the quartiles was not as linear as those of the quartiles based on brand or with the three moat rating groupings.
Yet for both equal-weighted and market-cap-weighted portfolios, quartile 4 stocks provided the highest geometric and arithmetic average returns.
What it All Means
One takeaway from these findings might be that investors should simply seek to avoid stocks with these three characteristics associated with popularity – good brands and reputations and economic moats – and focus instead on unpopular stocks, the ones that lack such attributes.
However, I believe a more nuanced take is a cautionary one. That is, if you ignore all other factors and buy stocks solely on the characteristics that make them popular, the authors’ research suggests that you are likely to pay a price for that choice. A great company may not make for a great investment; the characteristics that make stocks popular have, on average, already been accounted for in their prices.
This article is a version of a feature found in the US-published Morningstar Stock Investor magazine
