It sounds reasonable to say that investing in the most popular companies would produce the best returns, but this is just not how asset pricing works. Today on the show, we unpack the ‘good company is a good investment’ fallacy. Before diving into the main topic, we kick off our discussion on the subject of index funds with Robert Wigglesworth’s Trillions. From there, we share some updates about custom indexing and home buying in Canada, along with the immense valuation of Tesla as well as Elon Musk’s net worth. This acts as a great segue into the focus of today’s show: a so-called good company has high historical returns, strong earnings growth, strong forecasted earnings growth, and high prices. But just because the good companies have done well historically, this does not mean they will continue to be a good investment. In fact, there is a premium that says that higher-priced stocks earn lower returns than lower-priced stocks and value stocks. We unpack several papers that explore the concept that it is the lesser-known companies that tend to have better returns. We also get into how growth extrapolation, the skewness effect, and the big market delusion plays into the good company is a good investment fallacy. Our discussion concludes with the idea that investors are better off paying attention to expected returns rather than falling victim to extrapolation errors. Tune in today!
Key Points From This Episode:
Introductory comments: modifications to the show, listener feedback, and more. [0:00:30.2]
Book review of the week: Trillions by Robert Wigglesworth. [0:08:28.3]
News updates: custom indexing, Tesla valuation, homebuyer gifts, and more. [0:12:23.2]
Introducing today’s topic: the ‘good company is a good investment’ fallacy. [0:19:30:9]
Investing in good companies is irrational because of how asset pricing works. [0:20:44.7]
The threat that crypto and decentralized applications pose to good companies. [0:21:50.5]
Higher-priced stocks earn lower returns than lower-priced and value stocks. [0:24:40.3]
Findings from papers exploring glamorous stocks and investor bias. [0:27:21.2]
The problem of extrapolating growth too far into the future. [0:34:07.1]
Behaviour patterns of lottery-like stocks with high expected skewness. [0:37:17.4]
Declining prices and the big market delusion. [0:39:51.1]
The high prices and low expected returns of the NIFTY 50 companies. [0:44:05.2]
What the Fama French Five-Factor Model has to say about how assets are priced. [0:45:30.2]
Talking Cents: Questions about the price we pay for riches. [0:46:50.2]
Read the Transcript:
Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: You got that intro down pretty good now. Someone was asking you if we've actually had some in impact by changing the intro or not. It's been a little bit of feedback on it.
Ben Felix: The data haven't changed on downloads and stuff like that.
Cameron Passmore: Very quick, show recommendation for you. I don't know if you've seen this yet. Might be too young to really appreciate it, but a show that Lisa and I found yesterday called The 90s: The Last Great Decade?, which we found on Disney+. And who we knew I had Disney+ at home? Apparently kids subscribe to it. But there's two episodes, I think it's a three-episode series, but the first two are available.
It's a documentary made back in 2014, all about the '90s. Wow, it's amazing to see it put together like that. And for us gen-Xers, the number of huge events that happen in that decade are unbelievable. As they highlight this all before the internet, largely before the war on terror, before texting, and it goes through all these events and the impact that they've had on the psyche of people.
Things like the O.J. Simpson car chase, the Anna Nicole Smith episode, Seinfeld, Wars in Iraq, Somalia, Osama bin Laden, before he was Osama bin Laden, Microsoft, Apple, the Branch Davidians, the Oklahoma Bombing, the whole Tonya Harding saga with the Olympics, the Bobbitt story, it's just nuts. They actually gave the example talking about the O.J. story. They said that could be the last time where people actually come out to a live news event like that, because now if it happens, people will just watch it on their cell phones and on YouTube Live or something. Anyways, something for you to watch if you're interested.
Ben Felix: Why does all that stuff make it the last great decade, though?
Cameron Passmore: That's just the title of it. I'm not sure that's not actually true or not. But they highlight how these events happen in a pre-internet era. And communications really changed like broadcast news. They gave the example of the usage of chopper video of news events. That was something that happened that was created in the '90s. But now cell phones are everywhere, obviously, so everything is on film now. The Rodney King riots, it's just unbelievable.
Ben Felix: I'm not too young to remember the '90s, by the way.
Cameron Passmore: Right. But your memory, my memory might be a bit different.
Ben Felix: Yeah, that's true. Different memories.
Cameron Passmore: So we're going to make a modification to the podcast, the segment, bad advice of the week. I think you and I agree, we're going to let that fade away in into the sunset. We never really did feel great about doing it. Sometimes it felt a little bit awkward, although useful. I just don't think it's the tone that we wanted to set. Didn't quite feel right?
Ben Felix: Yeah.
Cameron Passmore: Recent reviews, Magic Bernie from Great Britain sent us a nice review. First came across you after watching your 5% Rule in YouTube, and for the first time he thought, "Whoa, at long last, someone that makes sense on the buy versus rent topic." That he found the podcast and listened to the one where we explained to your mom stock market price. So on the intro, as changing the content for Canadian made a difference. I suspect it will after a bit. He says the current stats then used to keep may have been different if the intro was different.
Ben Felix: We'll see.
Cameron Passmore: Todd Kiato says, great podcast to get behind the science of investing. Helpful for the retail investor. At the end of the day, majors VGRO and chill. Manuel V-1391 says best finance podcast. Says it's the best podcast on earth. I don't know.
Ben Felix: Best finance podcast on earth. Best finance podcast.
Cameron Passmore: Cameron and Ben are transparent and give evidence-based researched above and beyond. You guys are doing it right. It's very kind. They say, the leading finance podcast. Been following the Rational Reminder work for over a year. That's one of those rare gems you can find online for free with 10 out of 10 content. And yes, our intent is to maintain it free. And they proudly wear their Rational Reminder shirt around Seattle, Washington. So thanks for being our spokesperson in Seattle.
Love this one who said that you might be a robot. Evidence for Ben being a robot is that no normal human being can put out a weekly podcast, a YouTube channel, respond on the RR discussion form, read an unknowable number of peer-reviewed papers and books, work as a financial advisor and have a family with four young kids. Care to respond.
Ben Felix: I don't think I'm a robot. I wish I had a robot. If I could get some lithium polymer batteries that I could charge overnight and wake up feeling great with my fresh charge, that'd be nice. Have multiple battery packs too if you're a robot.
Cameron Passmore: That'd be pretty sweet. Don't have to sleep. Just recharge. Ramone Lapointe, who is our online friend and long time listener from Spain kindly says that it's the best podcast for financial curious. This is the best podcast for research and data-driven investing. Hosts offer a wide range of topics sprinkled with Improve Your Life podcast that he also appreciates is very kind.
Also want to highlight that the podcast is also on YouTube, in case you weren't aware. So if you want to see that Ben and I now have more colorful outfits on, you can check us out over there. And tip of the hat to our video editor, Matthew, who's done some really nice work, updating the look and feel of the YouTube.
Ben Felix: It looks great. You've got a colorful shirt. I'm wearing black. I don't know how color blind -
Cameron Passmore: This is new and fresh. You got that little fancy logo on there, so we're no longer just wearing our hoodies. Speaking of merchandise, Angelica saw some nice winter swag for us, some hats and scarves should be available in a few weeks. And she's also looking into that candle idea that we kicked around, those pretty funny comments on some sense that they had for the five different factors, pretty funny. Someone suggested that the value scent to use ramen.
Ben Felix: Yeah, there were lots of funny suggestions for, what does value smell like? What does a value stock smell like? It's so funny.
Cameron Passmore: The branded talking sense cards are still available. We've had lots of orders. We had an order to come in for six packs this weekend, which is now nice to get. And of course, every order gets a free pair of socks. We just ordered a new batch of socks to come into the store, so I suggest get you order in soon if you want it for sure for Christmas. Connect with us on Instagram and Twitter. I'm also on Goodreads.
Hey, I didn't tell you about my Peloton experience this weekend. Because I can roll eyes at this. She thinks I'm completely whack over doing this. But in the Peloton world, when you reach milestones, like at the hundreds, some people try to get a shout out if you go on a live ride. So I just realized yesterday it was my 700th ride, so I looked up for an interesting ride to try to do it live. So I picked one from London early in the morning here, so mid-afternoon there ended up, I was only 500 people or so, so I thought I had to go a chance and lo and behold, they got a shout out on the ride for 700 rides.
Someone like, there was an 1800 rides, 1500, a thousand and 800, then me at 700. But sometimes you go on it with a milestone. I was on one, once we tried to get a shout out, and there was hundreds of people they said that were on that ride wanted a shout out.
Ben Felix: I don't understand what that means. You wanted a shout from the instructor?
Cameron Passmore: Yeah. If you go live at a milestone, like I hit 700 rides, this was my 700th ride yesterday. So you go on a live ride when you know it's your next big number, and you just hope that they, because they'll scroll through the people that are reaching a milestone on that ride. So sometimes they tell you, "Well, there's too many people to mention, so we'll put it on our Instagram feed." And you go and see the feed, there's hundreds and hundreds and hundreds of names.
Because some of the rides will have four or five, 6,000 people on it. Well, this one on a Sunday, be more quiet, early morning, Eastern Standard Time, mid-afternoon in London time, happened to get a ride with not many people, so got a shout out. So reveals some deep level of insecurity I guess and perhaps.
Ben Felix: Sounds like evidence of Mark Zuckerberg's metaverse, you're valuing your online life as much as your physical life.
Cameron Passmore: Maybe I should settle the NFT of the screenshot of that or something.
Ben Felix: There you go.
Cameron Passmore: Anyways, anything else to add?
Ben Felix: No.
Cameron Passmore: Welcome to episode 174 of The Rational Reminder Podcast. So book review of the week, this book, if you're in the industry, it's an absolute must read. If you're interested in the history of indexing and evidence-based investing, it's a must read. The book is called Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever by Robin Wigglesworth. I love this book. I know we're in the business, I know we've been part of the story in Canada, which explains it. But I loved it.
Robin is the global finance correspondent for the Financial Times and is based in Oslo. And as many listeners know, our firm was a very early adopter of indexing ETFs going back to the mid '90s. And I can remember going to dinner with some of the Canadian leaders of creating the first ETFs, and just being blown away by how they worked, the creation redemption mechanism, how they might impact investors, how they might impact the industry, our business, unbelievable low cost. It was just absolute blow away technology to me.
This was of course at a time when the industry was, and especially in Canada, was laden with backend load, high MER, mutual funds and obsession with trailer fees in our business. And it felt so good to be right at the beginning of something that you could tell at the time, this was going to be a big deal. Even though it's been slow to adopt, you knew that this was going to be very, very important. And then once you get into this world of just understanding the mechanics of ETF and then it leads to, well, why doing indexes, and indexing makes sense, you get into the science behind all of this. And this just leads to all kinds of different people and characters and companies and ideas, and that is exactly what this book is about.
Robin goes back and interviews, all kinds of people. From academics to industry leaders, to company founders, and tells this story of these people and how this all happened. People's life from Vanguard, from BlackRock, Dimensional, Batterymarch, as well as a number of the academics. How did Vanguard start, for example? How did Dimensional start? Where did the ETF come from? This blew me away. Why did Bogle turn down the chance to be part of the very first ETF? How did Canada beat the U.S. to market with the first ETF even though it the idea was created in the U.S., Canada was first to market?
Ben Felix: What was the reason?
Cameron Passmore: I'm not going to give the secret away. Read the book. Just the regulations in Canada were a bit more relaxed, so they were able to pull it off.
Ben Felix: Because the same thing just happened or is it happening right now with the crypto ETFs, right?
Cameron Passmore: Exactly.
Ben Felix: Is it the same reasons?
Cameron Passmore: I don't know if the reasons are the same, but the spirit is similar, from what I understand. How did the science evolve over time? I remember Eugene Fama once said at a conference I was at that he just happened to be the right place at the right time. There was going to be someone with a brain power and technology that was going to put all this together. But how did the data get into the crisp database? Who was behind that?
And then he gets into what are the social impacts of so much money being controlled by so few companies? Is there too much power? Does broad index ownership lead to investor ambivalence, thus underperforming companies? The book interestingly starts out with bet made by our friend and past guest, Ted Seides that he made with Warren Buffett. Ted was a guest back in episode 61. So that's how the book actually starts. Anyways, can't recommend it enough. He's coming on the podcast in the new year. He's agreed to join us already. So go read Trillions.
Ben Felix: I have not read it yet, as usual, but I do plan to read it.
Cameron Passmore: Excellent. In other news, custom indexing excitement in the U.S. Will it come to Canada? I know we talked about this in our recent AMA. But thought we just highlighted a few things that have been going on in the U.S. market place. O'Shaughnessy Asset Management was sold to Franklin Templeton and the press release focused on their desire to acquire their Canvas platform, which is O'Shaughnessy's direct indexing platform.
This comes shortly after Vanguard announcing this past July that it was acquiring Just Invest, which describes itself as being delivering tax efficient, high-Personalized direct indexing solutions. Dimensional's also announced it will be offering its separately managed account service with lower minimums. I think 500,000 in the U.S., I believe. Plus Schwab plans to launch a direct indexing platform in early 2022 in the U.S., which is pretty big news.
And Michael Batnick talk about this on his recent blog. He called the article, Let the Games Begin. He highlights it the direct indexing world has been growing at 30% per year and is currently about 350 billion AUM in the U.S. And Michael Kitces, also a past guest, stated that Schwab entered the market, is declaring war on funds.
However, there are different opinions on this, so someone like Bloomberg analysts, Eric Balchunas said that direct indexing would probably find a small niche relative to the hype. "I've never been wrong betting against things trying to dislodge a three-basis point total market index fund, or ETF." So what do you think, where is this going to shake out? Is direct indexing going to be the next big thing?
Ben Felix: It can be sold. That's the thing. There's a chance it does grow, because it's a reason to... it's something that a firm can sell. Look, we have this thing, and they can charge more for it, obviously. Whether it's direct to Schwabor if it's an advisor charging for access to the service, or just offering access to a service, I think it'll probably grow. But whether it's merit-based growth or sales-based growth is another question.
I think there's definitely a use case for it, but it's always going to be the question of the use case relative to the cost, if it's three-basis points versus 40, to take out, or companies that you don't like. That's a ridiculous example, obviously, but in that example, would make a whole lot of sense. Maybe there's some tax reasons like in the Michael Batnick article that you mentioned, he makes some interesting cases for not needing to change a client's portfolio if they transfer from one advisor to another, or from a do it yourself situation to an advisor.
You don't have to sell anything. If they own a stock, it's appreciated a bunch. You just build the index around it. That's interesting, but you're deferring a cost. And if you're incurring a higher direct indexing fee to defer the tax cost, there's a trade-off there somewhere, but it's not a silver bullet that's going to make everybody more money.
Cameron Passmore: That's also potentially a gateway to more active management too.
Ben Felix: For sure.
Cameron Passmore: Or more decisions that are based on intuition as opposed to evidence.
Ben Felix: Oh yeah. It opens up all kinds of bad behavior, for sure. Let's drop oil. It's not going to do well in the future. Let's get rid of it. After a year where it's underperformed.
Cameron Passmore: Anyway, this is a whole different market in the U.S. They've got much broader, bigger platforms than we have in Canada, so I don't think it's going to be a big deal in Canada quite as quickly as in the U.S. But we'll see. We'll see what happens. Did you catch, as we are recording this, I think Tesla is up six or 7% today.
I saw a chart showing the Tesla is now worth more than all other publicly traded card companies combined. This includes Toyota, Volkswagen, Daimler, GM, BMW, Ford, Honda, Hyundai, Ferrari, and the list continues. Even Jim Cramer, read an article today, Jim Cramer said today that, "I've never seen a stock go up endlessly for nothing."
And then I looked up who are the largest holders of Tesla shares. The number one holder, Vanguard, $43 billion. Capital Group, which we talked about two weeks ago is the number two holder, BlackRock and then State Street.
Ben Felix: Wow.
Cameron Passmore: And get this, Elon Musk is now by far the wealthiest person on the planet, over 300 billion U.S. He's 100 billion ahead of Bezos. He's more than double Bill Gates. It's just absolutely incredible.
Ben Felix: Yeah, that is incredible.
Cameron Passmore: And a story you highlighted last week that you put into our archive here, article from stories, which is a residential new service, talking about the amount and frequency of gifts from parents to kids buying homes.
Ben Felix: Yeah, I put it in there because Rob Carrick mentioned it. And then I think somebody posted it in the Rational Reminder community.
Cameron Passmore: Okay.
Ben Felix: Just showing, here's what Rob was talking about. Because I don't think this article had come out yet when Rob talked about it. I guess he'd spoken to the economist from CABC who published the report that this story is about. But the average gift, according to this report, for a down payment, from parents to first time home buyers in Canada, is $150,000. And about 20% of Canada's first-time home buyers receive this amount. That's pretty crazy.
Cameron Passmore: Yeah, exactly. The thing I couldn't square from this article is that according to Equifax, the share of all home buyers across the country that receive support rose and 4.7% in 2019 to 5.5% in 2020. So still not a ton of people, it's talking about actually received support.
Ben Felix: Yeah. I don't know. Maybe they're different sources. I did not read the article thoroughly. Just thought it was interesting.
Cameron Passmore: It also talked about homeowners that already owned a property and were in the market for an upgrade received $200,000 on average from their parents. The number of people receiving help from their parents has doubled in recent years. And we talk about how the availability of cash due to reduce spending during the pandemic also helped provide funds to the next generation. So suffice to say, more and more parents are helping their kids get into the market.
Ben Felix: Which is great if the market keeps going up. But if it doesn't and ever goes down, it could be interesting. But we could have said that three years ago, four years ago, five years ago, and it has kept going up, so no point in speculating that it's going to go down.
Cameron Passmore: As I said, my house I bought in 2003, dollar for dollar for 15 years, didn't move at all.
Ben Felix: Really?
Cameron Passmore: We take what we paid and what I put into it. Did some renovations and stuff. Dollar for dollar, didn't move.
Ben Felix: Even now?
Cameron Passmore: Oh no, for the first 15 years. Oh no, in the past four years, it's up 50%.
Ben Felix: Just going to say, you must've done some serious renovations in the last couple of years.
Cameron Passmore: Now it's getting a little tired, so.
Ben Felix: How much did you say in the last couple years?
Cameron Passmore: 50.
Ben Felix: Wow.
Cameron Passmore: Probably I'm just guessing, it's probably 50% in the last three, four years.
Ben Felix: That's wild.
Cameron Passmore: Yeah. So I think you picked a pretty good main topic for this week.
Ben Felix: Wow, well I hope so. I've been doing a lot of reading on crypto and that's not what this topic is about. This is just something that has been on my mind for a long time. And when we talked to John Cochran, he mentioned it and that reminded me or reinvigorated the idea. But it's the good company is a good investment fallacy. He made reference to that in the episode and I was like, "You know what? I've got to do that topic because it's just been in the back of my mind for a long time."
I think anybody that dips their toes into investing for the first time, it seems pretty easy. You just buy good companies and hang on to them. We just talked about Tesla. You just buy Tesla and hang on to that forever because it's a good company and they're changing the automotive industry and other industries. You just buy good companies.
Cameron Passmore: Pretty easy.
Ben Felix: Pretty easy, right?
Cameron Passmore: Set and forget it.
Ben Felix: And it's not just individuals. I've actually heard institutional active managers, intelligent people, educated people, describe their approach as investing in companies that you've heard of. Good companies, good solid companies that you've heard of. As if that's a good thing. That's something that you want in an investment strategy.
Now the problem of course, is that, while that sounds easy, it's not really how investing and asset pricing work. So I want to describe this fallacy and why it exists. And the fact that it does exist. I think that the empirical component is pretty interesting too. From how many different angles is this fallacy through.
Popular companies, the companies that you've heard of like Tesla we just mentioned, Amazon, Google, Facebook, all those types of companies today. Other than they've all got great stories behind them in terms of their stock returns, in terms of their businesses. And they've all got pretty good prospects ahead of them, I think. Facebook just announced some pretty big changes to theirs. I haven't paid attention to the price. Do you know how the market reacted to that?
Cameron Passmore: Have not got paid attention. But it's interesting you mentioned crypto. Because there's so much cool stuff going on there. But is it obvious to you what's going to win?
Ben Felix: That's another topic for another day. But no, I don't think anybody can tell you what's going to win in crypto. Just like I don't think anybody can tell you what's going to win in internet companies in 1999. I think you can know that it's going to be a thing and it's going to be a big deal and it's going to change a lot of stuff. But I don't even think we understand the use cases yet for decentralized applications in general.
Just like we didn't understand what the applications for the internet were going to be. You look into the internet of 1999. People were just putting content that previously existed onto computers. But then eventually we get social media and it's like, wow, that changed everything.
Cameron Passmore: Good search.
Ben Felix: Yeah, good search. Organizing the world's information like Google's mission is. Anyway, so companies with good prospects ahead of them, which I think a lot of the companies have high prices today. They probably still do have good prospects ahead of them for quite a long time. Unless crypto disrupts them, which is I think a distinct possibility. But I think that'll probably take a long time, if it's going to happen. And I'm not predicting that.
But there's some pretty interesting applications for crypto that could potentially replace things like Google and not for crypto, for just decentralized applications that could replace a lot of what these companies have all centralized the distribution of information in different ways.
Cameron Passmore: That's exactly it.
Ben Felix: And they're profiting from it in a decentralized world. The users could be profiting from that but anyway.
Cameron Passmore: That's what's so interesting about the podcast we both listened to it with Tim Ferris. The whole notion of Spotify capturing the rent, as opposed to the musicians. That incredible potential world decentralization with the power going to the creators could be unreal.
Ben Felix: Yeah. And you know what? It feels like a digression, but it's actually not. Because what happens, Fama and French had the 2006 paper, but I've got this way down further in my notes, but I'll mention it now. The anatomy of value and growth stock returns, where they look at, where do the returns of value and growth stocks actually come from? What happens that results in those premiums?
And for growth stocks, that negative performance relative to value tends to come from convergence, from their prices basically being too high. Or from a deterioration in their business fundamentals. But either way the evaluation metrics converging down. You get a rising cost of capital and all of a sudden your valuation decreases, and that's what causes the relatively poor performance of growth stocks compared to the value.
And when does that happen? Well, when the businesses reached limits to growth or competition or disruption. Five years ago, I don't think anybody could have guessed what could disrupt Google or YouTube. Same thing I know. And now, there're ideas floating around that, hey, maybe decentralization could be the thing. Anyway, that's enough of the digression.
These companies that seem to have great prospects ahead of them, they'll tend to have higher prices because more people want to own them. And they'll have lower expected returns because the investors are willing to supply capital to these companies at a lower cost because they have such strong prospects. Now of course, this has been studied from all kinds of different angles. And we know there's a value premium or there hasn't been for the last little bit, but there historically. It hasn't been in the U.S. and in other countries, there has still been a value premium, but in the long run, I think it's pretty well-documented that there is a premium where higher price stocks earn lower returns than lower price stocks, that value stocks.
And value stocks tend to be the companies that you have not heard of. And we're talking about this good companies, a good investment fallacy. It's the ones that you probably wouldn't say, yeah, I want to own that. It's those ones that tend to have better returns. I mentioned Facebook, Apple, Google, Netflix is in there, Microsoft, Tesla. There's probably other ones that could fit in that list. They're all huge. Everyone knows them, knows the companies knows their products. They're generally admired, although they've definitely taken some political flack recently for their role in, well, just in what's been going on in the world.
But that aside, they've all got robust businesses. They're cranking the profits and earnings growth. Those are objectively good companies by anything you want to measure them by. Except for their impact on society, maybe, but that's a separate discussion.
Then the other piece of that is that on their path to becoming the companies that they are today, if you had the foresight to own them from their IPO until now, you would have become just tremendously wealthy. They've got high historical returns, they've got strong earnings growth, strong forecasted earnings growth, and high prices. That's a good company. And there's a paper actually that I'll mention in a bit that defines a good company with roughly, I think the metrics that I just said.
The question we have to answer is whether an objectively good company is a good investment going forward. We can know that they were historically good investments and that's often obvious and it's one of the things that I think causes problems for people, but on a go-forward basis, are these things going to be good investments? There's a CFA research foundation publication. It's a PDF. It's available online.
It's called Popularity: A Bridge between Classical and Behavioral Finance. And in this book, the authors develop an asset pricing model that includes measures of popularity. So it's coming back to that idea of companies that you've heard of, or companies that you hold in high regard or are those good investments. They sort stocks based on brand value, measured by Interbrand's annual Best Global Brands report. Competitive advantage measured by Morningstar's Economic Moat Ratings, which assesses things like network effects, intangible assets, cost advantage, switching costs and efficient scale and company reputation measured by Nielsen's Harris Poll Reputation Quotient.
They took those three measures of popularity and they asked, how does that affect asset prices and realized returns? For the study period, from 2000 to 2017, they find a monotonic negative relationship in their sample between brand value and stock returns. I need you to think about the highest brand value stocks had much lower returns and lower Sharpe ratios and lower brand value stocks.
Cameron Passmore: Wow.
Ben Felix: Interesting, right?
Cameron Passmore: These are the top ones in 2000?
Ben Felix: It's an index, so it would have been reconstituted.
Cameron Passmore: Each year. Fascinating.
Ben Felix: Yeah. Over this period of dollar invested in the least popular stocks measured by the brand value, dramatically outperformed the most popular stocks for competitive advantage. They find from July, 2002 to August, 2017, which is their sample period that companies in the sample with no competitive moat, beat the companies with the widest moats by a wide margin. This is one, this is the Warren Buffett type, buy companies with wide moats. Now, in this case, this is the one example where the companies with no moat outperformed, but they were more volatile.
Cameron Passmore: Hard to believe it with companies and they're like Apple and Netflix, unbelievable brands that have unbelievable stock appreciation.
Ben Felix: Yeah, that's true. And then the companies with the best reputations from 2000 to 2017, they trailed companies with the worst reputations by over 5% per year, while also being more volatile. So wide moats, good brands, underperform as opposed to high perform, which is the opposite of what many people think. Meir Statman and Dennis Engineer, I'm sure I just butchered that name. I apologize. They had similar findings in their 2010 paper stocks of admired companies and spurned ones.
They found that from April, 1983 through December, 2007, that more admired companies measured by Fortune Magazine's annual list of America's most admired companies had lower returns on average than the stocks of spurned companies. And they found that increases in admiration are followed by on average lower returns. Similar ideas. Then I found the 2010 paper Glamor Brands and Glamor Stocks by Bill, Jang and Rigo. They found using unique data set, based on customer opinions about the perception of our company's brands that prestige and the product market, associated with glamor in the stock market, so companies that have products with high brand prestige is associated with glamor in the stock market like growth, high prices.
The effect decreases with institutional rather than retail ownership of the company. And then they find that companies with high prestige tend to have low future returns as we would expect because they're glamorous stocks. But I thought the institutional ownership angle is interesting there, where the effect decreases with institutional rather than retail ownership of the company. So it's suggesting that institutions are not prone to this bias, but retail investors are prone to the bias where if there's positive association with a brand, that we're willing to pay more for the company stock and therefore get lower returns.
Cameron Passmore: And that is not surprising.
Ben Felix: It's not surprising, but it's fascinating.
Cameron Passmore: Yes.
Ben Felix: 2011 paper, investor sentiment, stock characteristics and returns, Meir Statman again, explains and finds evidence in support of the sentiment hypothesis, which states that sentiment misleads investors into believing that the stocks of companies with relatively positive sentiment will yield higher returns than the stocks of companies with relatively negative sentiment. And that sentiment is elicited by the names of companies rather than by their characteristics.
The sentiment hypothesis claims that names of some companies elicit positive sentiment and that the halo of positive sentiment misleads investors into the belief that these stocks will provide high future returns with low risk. Also crazy. And of course, that combination of high returns with low risk, which is what investors perceive, is unrealistic. You can't get that. And it leads to low realized returns for the investors who are willing to pay high prices for those stocks.
And then there's this famous paper in 1994, Contrarian Investment, Extrapolation and Risk by Lakonishok, Shleifer and Vishny. They explained that, this is where I got that definition that I mentioned earlier. So glamorous stocks, stocks that have performed well in the past and are expected by the market to perform well in the future, inferred from their price being high. May under perform value stocks because investors make judgment errors that extrapolate past growth rates too far into the future.
Or investors may simply make the era that well-run firms are good investments regardless of the price. And then be willing to overpay to invest in the business. Glamor companies tend to be, some growth stocks tend to be companies that have done well in the past and are unlikely to become financially distressed in the future, which makes them attractive to institutions who want to appear prudent. I thought that was interesting. Little limits of arbitrage argument in there.
But if that prudence like to say, we're going to invest in stable companies, we're going to invest in companies that you know. Telling that to a not-for-profit board sounds really good, but it's not actual prudence. It's a story that investment managers tell. And they say this in the paper.
Cameron Passmore: Peter Lynch was famous for that. Go to the mall, investing companies your kids like, understand the products.
Ben Felix: Buy what you know.
Cameron Passmore: Buy what you know, have great returns.
Ben Felix: Yeah. So actually for envisioning the show, as we would expect that glamor stocks earn lower expected returns than value stocks. And they are also found that they're not fundamentally less risky than value stocks, which that's an interesting finding too. That was the basis for saying, this is just a story investment managers tell. These companies are not safer.
But always is going to depend on your definition of risk, of course, but based on the three definitions they had to make that statement. They found that they were not less risky. Hersh Shefrin, a fairly recent podcast guest, he explains in his 2019 paper, Valuation Bias and Limits to Nudges, which we talked about in the episode with him. He finds that the analysts are also prone to extrapolating growth too far into the future.
He shows that all sell side analysts covering Facebook, Amazon, Netflix and Google, exhibited growth opportunities bias. They basically assumed that the firm will be able to maintain exceptional growth forever, which is not what has historically happened with successful companies, like I mentioned earlier. And then this one's a little different in terms of thinking about popularity, but I think it's really interesting.
So tail risk. This came from the popularity book as well, but they suggest that investors don't like tail risk, measured by negative cost skewness with the market. It's like stocks that tend to do really badly when the market does badly. And so, their argument is that those stocks should be less popular. Those are more likely to be the types of companies that we would think of as not being good businesses.
I thought it was interesting just reading the book. This is obviously written prior to last year. Well maybe that's not obvious. The book was written prior to last year. But you think about what happened when all of the objectively good companies like Amazon and the other tech companies we've been talking about, they relatively did okay when things started tanking. So you didn't see that negative cost skewness.
Cam Harvey and the coauthor, obviously another recent guest, they found in their June, 2000 journal of finance paper, which we also talked about when Cam was on, conditional skewness in asset pricing tests. They found that conditional skewness is priced, commanding a risk premium of 3.6% per year on average in their sample. And then back to the popularity, the CFA book. The authors extend Cam Harvey's cost skewness sample for the subsequent 20 years after Cam's sample. And then they find that companies with the most positive cost skewness, the ones that decrease tail risk in a portfolio, crail those with most negative cost skewness units by 4% year, so closest to what Cam found.
Then their argument is that given that, investors should theoretically prefer positive cost skewness over negative, they're suggesting this is further evidence of the popularity hypothesis stocks that you want to own. For us talking about this, of course it makes sense. And for a lot of listeners, maybe it makes sense too. But for a lot of people, it's pretty counter-intuitive that stocks that you don't want to own, those are the ones that have high expected returns. If you want to own a stock, it's probably not a good investment.
And then the last one from the popularity book was lottery stocks, so stocks with highly positive unconditional skewness. Meaning a high probability of weak returns with a low probability of extremely positive returns. And we know empirically that those lottery stocks are popular with retail investors particularly, and they've historically performed really badly. Which is why IPOs generally aren't good investments.
A 2011 paper title IPOs is lotteries skewness preference and first day of returns. The authors explained that IPOs with the highest expected skewness experience the biggest first day pops. But they also find that IPOs with high expected skewness earn more negative abnormal returns in the first one to five years after the IPO. So the more lottery like stocks have big first day pops because all the retail investors pile in, this is theoretical, I guess. All the retail investors pile in to buy the stock. But then they go on to have really bad returns.
High expected skewness is also associated with a higher fraction of small size trades in the first day of trading, which the authors of this paper suggest is consistent with a greater shift in holdings from institutions who don't have this skewness preference to individuals who are actually willing to pay a high price for it. The more a lottery like the pay off, the higher the first day pop, the lower the expected returns.
But again, people really want to own those IPOs. Anecdotally, we do see this. We see this when big IPOs happen. I wouldn't say it's something that happens a ton, but it's definitely a time where we will get emails saying, what do you think about this IPO? Should we be investing in it? And it comes back to that Barber and Odean findings about attention, investors are more likely to invest in stocks that grab their attention and big IPOs tend to be very attention grabbing.
But of course, as an investor, it should be obvious, I guess, by nature of the name that they're given, lottery stocks. Lotteries aren't good deals. Buying lottery tickets is not a good deal, just like buying lottery stocks is not a good deal, but they're still very popular.
One of the other important pieces here, and this comes from Brad Cornell, who's another podcast guest. It's cool, lots of podcasts guests that I'm referencing. I was thinking about that though. And it's like, if we continue getting the type of guests that we've been getting, at some point it's going to be difficult to prepare research without reference to past podcast guests.
Cameron Passmore: Start as a work on the year end episode, pulling together all the different show notes. A lot of pretty good conversations we've had this year.
Ben Felix: No, it's amazing. Very grateful for that. Another big piece of this I think is what Brad Cornell, and actually we talked about this with Rob or not, to the big market delusion. Just the idea that when a new market develops like crypto, this is I think when I prepare my formal written research on crypto. I think this is going to be part of it. The big market delusion, where all of a sudden a new market appears.
We saw it with cannabis. We saw a full cycle with cannabis and that happened quick too. Where everyone's like, "Wow, this is going to be huge." And they weren't wrong. But all of the companies that emerge get priced as if they're going to be the winners in that market. But of course that doesn't happen. There's extreme skewness and you get very few winners. Again, and I think this is another big issue, where people look at companies in a new industry. This is less so for established companies. They look at companies in new industry and say, "Hey, this is a good business."
And you can be right about that. But because of the skewness, as things shake out, you end up with pretty bad returns. And Cornell had a paper , and they give the examples of E-commerce in the 1990s, online advertising in 2015 and cannabis in 2018. And they do a case study for each one, which was quite interesting to read. And they're all the same story. It's a big potential market. There's a lot of excitement and new business formation and high asset prices relative to business fundamentals. And it's the same story, but then you get declining prices and bad returns if you tried to capitalize.
So again, we see these were good companies with good ideas and good business plans, and exciting industries, but with very high prices for all of the same reasons. Not such good investments. When I was going through all these different papers and stuff trying to put my thoughts together on this, one of the things you realize is that this is all particularly salient today. Because value's gotten clobbered by growth, glamor.
The companies that people want to own are the companies that have in fact been performing very well despite their low expected returns. It's a relatively small number of companies that have become very dominant in the stock market and I think in the hearts and minds of investors. Find somebody in the street, they've probably heard of Tesla. And these companies now have high prices because they're profitable and they've got these strong, expected earnings growth.
That's always true. Growth stocks were always well, by definition, growth stocks are going to have higher prices. Growth stocks tend to be better businesses. They tend to be more profitable. They tend to have stronger expected earnings growth. That difference in valuation between value and growth stocks is the value spread.
At the end of 2020, the value spread was as wide as it has ever been by the metrics used in one of the papers. We'll put a screenshot of their chart up on the YouTube video. And the other interesting thing in this paper that I'm referring to found is that analyst forecast for future earnings, the spread in analyst forecast, was also historically wide. That's interesting, right? I mean it makes sense though, like expected earnings, therefore evaluations are high.
I thought it was interesting that there's a positive correlation between current prices and analysts forecasts. It makes sense. It's just interesting to see it. The paper from Fama and French that I mentioned earlier, the anatomy of value and growth stock returns, they showed empirically that growth stocks, the good companies tend to eventually see their evaluations decrease as their profitability and earnings growth decline and their cost of capital increases. And they call that convergence. And the convergence and valuations is largely what explains the under-performance of glamorous stocks relative to their less glamorous peers to value stocks.
Now, there's always the possibility, and we've talked about this. Lots over the years on the podcast, there's always a possibility of this time is different. But those are pretty expensive words, historically, in investing. And it's hard to not think about the nifty 50 example here because that time was different too. And that of course is the 50 stocks in the 1970s. There was IBM, Xerox, McDonald's, a bunch of other ones. Again, objectively good businesses.
But they started trading at price multiples that were more than double the market, more than double the S and P 500 at their peak, which was in 1972. And they went on to have, well, not so great returns. They had very strong returns leading up to that peak. Their valuations got higher and higher and higher, and at a certain point, it wasn't sustainable anymore. And they went on to have very weak returns.
Now, if you held onto those companies, I think you actually did okay. I think the nifty 50, a lot of those companies have gone on to, you need to have decent performance. But high prices lead to low expected returns. If you bought them at the high prices, you didn't do so hot.
Cameron Passmore: We talked about Cisco. I think it was two weeks ago. The Cisco price, just getting back now to where it was 21 years ago.
Ben Felix: Right. That's another great example. I think the key is that good companies are only good investments if they trade at good prices. But counter-intuitively, bad businesses can also be good investments if they trade at good prices.
Cameron Passmore: At a good price.
Ben Felix: Then of course, the Fama French five-factor model suggests that it's not just price. There's company size, relative price, profitability and growth and the book value of assets. Those are the factors in their model that theoretically explain how assets are priced, with of course, lots of empirical support for the model. Based on their model, small companies with low prices, robust profitability and conservative asset growth have higher expected returns than large companies with high prices, now robust profitability and aggressive asset growth, and the book value of their assets.
And what I just described there for the larger company example, that's basically what a lot of the companies that people would say, yeah, that's a good business, I want to buy that. They tend to be those larger companies. And I think that's larger companies with high prices. And that's one of the key challenges for investors. Investors are better off paying attention to expected returns, given the information available in market prices, rather than falling victim to the extrapolation errors that investors seem to systematically make when they're choosing which companies they want to invest in.
Cameron Passmore: Well, great piece. On to talking sense?
Ben Felix: Let's do it.
Cameron Passmore: So these again are from the University of Chicago Financial Education Initiative, and we have our branded cards available in the store. Question number one. It's a quote from Ralph Waldo Emerson. Money often costs too much. What do you think this means? I think of two things about that. One is, often to get money up to work an awful lot and perhaps you lose balance in your life. That'd be number one. You hate to give up a balanced lifestyle just for more money.
I often think if you have a lot of money, there could be a lot of other overhead, a lot of other trappings of life to come to a bigger houses, more houses, more stuff, more things to worry about, which may cause you to drift away from what's really important to you and makes you happy. What do you think?
Ben Felix: I think it's what The Notorious B.I.G. said, "More money, more problems." Seriously, I think it's true. I think a lot of people that have more money through either the pursuit of money or through nature of having it, end up bearing costs greater than what you would expect.
Cameron Passmore: Here's question number two. Would you do something you knew was wrong if it meant getting lots of money? And how much would someone have to pay you?
Ben Felix: Well, how wrong is the thing? How wrong is the thing?
Cameron Passmore: Hey, if you knew it was wrong, would you do it if it meant getting lots of money? And how much would it have to be?
Ben Felix: If it's something really wrong, then there will be no price. But I think it's like what you said, there's a gradient of, I can't think of any good examples. But for the right amount of money, there's definitely stuff I can do and then not fret about it too much.
Cameron Passmore: It would help you get over the guilt of doing it.
Ben Felix: But then other things that there's no price, so that's a tough one to answer without both sides of the equation.
Cameron Passmore: The third one I pulled, I think we've had this one before, but I could be wrong. What career would you choose if all jobs made the same amount of money?
Ben Felix: You answered first.
Cameron Passmore: Well, I said in the past, I would love to be a surgeon. I love to be in healthcare like that. Also talked about working on a beach and teaching wind surfing. Think that'd be cool, or a fishermen in the small village, the Caribbean or something. Loved it when I was a kid as a butcher. Kind of dirty, kind of messy, but still I loved aspects about it. I love what we do now with you.
Ben Felix: I don't know, it's a tough one. I worked as a informal apprentice to a carpenter for every summer when I was in high school. That was great, but physically taxing, I don't know if I'd be able to do that now, after my years of playing basketball. My body doesn't feel the same as it did when I was 16. I don't know. I very much enjoy the aspect of my job now where I get to read and write about stuff that's interesting. And anything that's like that I think is pretty enjoyable.
And we actually talked about that a little bit with one of our upcoming guests about how you can derive pleasure from pain. And pain can include stuff like focused reading and writing and stuff like that. Where if you can sustain that type of work, because it is physically uncomfortable for humans to do that. If you can sustain it for long enough, you get a dopamine release, which is pretty interesting.
Cameron Passmore: That was Dr. Anna Lembke. Is coming up in three weeks time, I believe. Next week it's Robin Todd is up.
Ben Felix: Yeah. We should tell people briefly that we had a special guest planned for this episode, but it ended up not working out, so we would have normally had a listener question in the episode as well, but it ends up just being a bit of a shortened episode today.
Cameron Passmore: Anything else to add, Ben? I'm not saying it.
Ben Felix: I saw your smirk about the episode line.
Cameron Passmore: I'm not going there.
Ben Felix: Neither am I. I've got nothing else. We're good.
Cameron Passmore: All right. Great. Thanks for joining us.
Books From Today’s Episode:
Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever — https://amzn.to/3DXhUe4
Popularity: A Bridge Between Classical and Behavioural Finance — https://www.cfainstitute.org/en/research/foundation/2018/popularity-bridge-between-classical-and-behavioral-finance
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/
Shop Merch — https://shop.rationalreminder.ca/
Join the Community — https://community.rationalreminder.ca/
Follow us on Twitter — https://twitter.com/RationalRemind
Follow us on Instagram — @rationalreminder
Benjamin on Twitter — https://twitter.com/benjaminwfelix
Cameron on Twitter — https://twitter.com/CameronPassmore
'The Anatomy of Value and Gross Stock Returns' — https://www.jstor.org/stable/4480889
'Stocks of Admired Companies and Spurned Ones' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1540757
‘Glamour Brands and Glamour Stocks’ — https://www.sciencedirect.com/science/article/abs/pii/S0167268114000845
'Investor Sentiment, Stock Characteristics, and Returns' — https://jpm.pm-research.com/content/37/3/54/tab-pdf-trialist
'Contrarian Investment, Extrapolation, and Risk'— https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.1994.tb04772.x
'Valuation Bias and Limits to Nudges' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3225439
'Conditional Skewness in Asset Pricing Tests' — https://onlinelibrary.wiley.com/doi/abs/10.1111/0022-1082.00247
'IPOs as Lotteries: Skewness, Preference, and First Day Returns' — https://www.researchgate.net/publication/261970609_Initial_Public_Offerings_as_Lotteries_Skewness_Preference_and_First-Day_Returns