Why popular stocks may not make the best investments

Christian Charest: For Morningstar, I'm Christian Charest. Does a company's popularity provide any insights as to how its stock is likely to perform? That's the topic of an upcoming research publication. And I'm here today with one of the co-authors of that research, Morningstar's Dr. Paul Kaplan.

Paul, thanks for joining us today.

Paul Kaplan: Thanks for having me.

Charest: To start with, can you explain what exactly you mean by popularity in this context?

Kaplan: Yes. In this context, where we are talking about securities and stocks in particular, what we are talking about is, what characteristics do those securities have that investors like, that they want. What is it that might draw them to particular securities? And on the flipside of that, there are securities that can be unpopular, and they have characteristics that investors don't like, and they would shy away from.

Charest: And what are the characteristics of popular stocks?

Kaplan: Well, we could divide the set of characteristics of stocks into two groups; one based on what we call the classical financial theory, the basic theory that says that investors behave rationally, and markets are efficient and so on. And so, those characteristics would include expected return, that investors like expected return; risk, investors dislike risk, so we could say risk is unpopular; as well as some additional characteristics that investors from a rational point of view should care about such as taxability, how much taxes would they have to pay from that security; and liquidity, liquid stocks are going to be more popular than less liquid stocks.

On the other side, there is this behavioural side, which comes from the field of behavioural finance which looks at people's psychology and asks questions about, well, what is it that would attract investors to a particular security. So, in this case, it's going to be something that's going to be more emotional. It might be because the company has a great brand and not just because that great brand makes the stock intrinsically more valuable but just because investors, maybe they just like the feeling of owning that stock or owning a company with a great reputation and things like that that are really more based in behaviour, based in emotion and are often just irrational.

Charest: And from an investors' point of view then based on your research what can popularity explain?

Kaplan: Popularity explains a number of the different phenomena we see in investing that we typically call premiums or anomalies. So, one of the best-known ones is the value premium. It's the idea that if I build a portfolio of stocks that have low valuation ratios that basically compared against some measures, such as book value, earnings and so forth, are less expensive, portfolios of those stocks will over time tend to outperform the ones that have richer valuations. And so, you might ask, why should that be.

And popularity provides an answer to that question. It says that those companies which tend to have low P/E, low price-to-book and so forth, those companies tend to be the stocks that you might call the unloved stocks, the unglamorous stocks, the stocks that get very little attention paid to them and so on. And because they are unpopular, they are going to typically trade at lower prices and over time produce higher returns.

Charest: So, these factors that you have mentioned, obviously, there are already a lot of ETFs that are designed to take advantage specifically of those factors. So, would you say then that those factor ETFs, even though they don't call it that, they are in effect taking advantage of the popularity effect?

Kaplan: That's right. And there are a number of different effects that -- there are a number of ETFs that are currently trying to take advantage of these effects which we are calling popularity. They may not use the term, but in effect, that's what they are doing. So, value, small company portfolios, portfolios maybe that are less liquid, portfolios of an interesting set of anomalies are the low volatility anomalies, which kind of turns the whole risk/return relationship on its head. So, it says, if I create a portfolio of stocks that are less volatile, I actually could end up with higher returns than a portfolio that has high volatility stocks. So, we get high return and low risk going together which runs contrary to sort of the classical financial approach, which can be explained by popularity.

Charest: Now, these factors that you mentioned, low volatility, value and so on, those are very well supplied in the ETF world. Are there any factors or anomalies that are not yet exploited that can be explained by popularity?

Kaplan: Yes. One of the things we did in conducting our research was we went beyond simply those, sort of, well-known factors. And we looked at factors that we thought might be related to popularity which are not currently being exploited in investment products.

So, there were three in particular we paid attention to. One was brand value. And there are external measures of brand value where companies are ranked. And it turns out, by building portfolios over time of companies that have a lower brand value versus those with a higher brand value, the interesting thing is that ones with the lower brand value outperform the ones with the high brand value. A similar thing happens with reputation. So, companies that have a great reputation actually perform lower, they have lower returns than companies that don't have that greater reputation.

And the third factor is competitive advantage which we use, the Morningstar moat measure. And what we found was that basically the same phenomena that companies that don't really have a moat in terms of having a competitive advantage actually outperform portfolios of companies that have a great deal of competitive advantage.

Charest: I suppose it would be hard for a fund company to market itself as investing in weak brand companies and companies with bad reputations. Now, this brings up an interesting conundrum, because one would think that companies that enjoy a great reputation, solid brands and good competitive advantage would make for great investments. But that's not necessarily the case. Why is that?

Kaplan: Well, that goes back to something which I think is somewhat well-understood but not necessarily always well-understood. And that is that a great company does not necessarily make for a great investment. You really have to pay attention to how much you have to pay for that company. And if popularity is bidding up the prices of these great companies, you are not going to get great returns out of them.

Charest: And what lessons should investors draw from your research then?

Kaplan: Okay. Well, a few basic lessons. One is that when you are looking at, let's say, an ETF and it does have some kind of a strategy to it that's based upon some kind of factor, what's the story behind that factor? It's not enough just that that strategy back-tested really well in the past because that may not mean it will do so in the future. So, is the story really solid, can you really tell the story? And popularity is a great tool for telling a story. If you think this particular factor that that ETF is floating up on is an unpopular factor, well, that may be a good reason to go with that strategy.

And also, if you are an investor who picks individual stocks, really pay attention to the popularity effect. Because popularity is telling us there's more that's going into stock prices than just things like the discounted cash flow.

Charest: Paul, thank you very much for sharing your insights with us today.

Kaplan: Thank you.

Charest: For Morningstar, I'm Christian Charest. Thank you for watching.