Beat the market with big stocks
Think that GE, P&G, J&J, Microsoft and other big stocks will only muddle along? A new study suggests otherwise.
NEW YORK (MONEY) -- Small investors may flock to the most popular stocks, but it's a core belief of academic experts that companies whose strengths are widely recognized won't be able to beat the market over the long-term.
According to the so-called Efficient Market Theory, any positive characteristics of a well-known company will quickly be reflected in its share price.
At best, the stock will meet investors' expectations in the future and move up in line with the overall market. Any surprises are likely to be negative and result in a sudden price drop.
To test the experts' conventional wisdom, two pros recently did a statistical study of the performance of the most popular companies, which appears in the current issue of the Financial Analysts Journal (July/August, Jeff Anderson and Gary Smith, "A Great Company Can Be a Great Investment.")
Their study tracked the performance of shares in Fortune Magazine's annual list of the Most Admired Companies (see the 2006 list). The companies are selected by polling some 10,000 corporate executives, directors and stock analysts. Both Fortune and Money are published by Time Warner, owner of this Web site.
Surprisingly, the stocks on Fortune's list outperformed the market over a 22-year period, even if investors waited to buy until several weeks after the Fortune lists were published.
"A portfolio of these stocks outperformed the market by a substantial and statistically significant margin," say authors Anderson and Smith. "This result is a clear challenge to the efficient market hypothesis, because Fortune's picks are readily available public information."
Not every Fortune pick provides superior long-term returns, of course. General Electric, for example, was long one of the most admired companies but has underperformed the S&P 500 since January 2002.
Still, Fortune's list offers a collection of some of the best companies in the world, judged by such measures as innovation, quality of management and financial soundness. And the shares of many of them are relatively cheap, compared with their historical price/earnings ratios, because big growth stocks as a group currently seem depressed.
Twelve of the top 20 stocks on the most recent list are also on the Sivy 70 list. To try to identify timely bargains in the group I looked at their value ratios, which compares potential total return with a stock's P/E, based on projected 2007 earnings per share.
To approximate a stock's total return, I add the stock's current dividend yield to its projected long-term earnings growth rate. This assumes that a stock's price appreciates in line with the company's earnings growth.
Unlike the similar but better known PEG ratio, this value ratio also includes the return that comes from cumulative dividends, so as not to discriminate against more conservative growth & income stocks.
The 12 stocks are ranked in the table below by value ratio, starting with the cheapest.