These stocks can push your portfolio from good to great

Companies that business experts admire have delivered for investors.

  • By Gary Smith,
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Many business executives, management consultants, financial analysts, and investors have ransacked lists of thriving companies, looking for shared characteristics that explain their success. The results are generally disappointing in that the traits that are discovered are more likely to be coincidences than secrets for success.

The fallacy of selecting traits after identifying successful companies is known by a variety of names, including the “Feynman Trap” and the “Texas Sharpshooter Fallacy.” This latter fallacy supposes that a self-proclaimed (Texan) marksman shoots a bullet at a blank wall and then draws a bullseye around the bullet hole. This proves nothing at all, because there will always be a hole to draw a circle around. In the same way, any group of companies (great, good, or bad) will inevitably have several common characteristics. Since we are bound to find shared traits, finding some proves nothing. A persuasive test of any set of proposed secrets for success must specify the traits beforehand. The target must be drawn before firing the gun.

The Fortune list is based on a set of ex ante criteria identified before comprising the companies. The same measures of successful companies are used year after year. Instead of looking for ex post traits that are common to admired companies, it looks for companies with admirable traits that have been specified beforehand.

The performance of Fortune’s 10 most-admired stocks can be analyzed by constructing an Admired portfolio. The Admired strategy begins by investing $1,000 in each of the 10 most-admired stocks on the 1983 issue’s official printed publication date.

Each year thereafter, the portfolio is liquidated on that year’s publication date and the proceeds are invested equally in that year’s 10 most-admired companies. (Investors can easily implement this strategy because the magazine appears roughly a week before the stated publication date.) For comparison, an Index strategy was created by investing $10,000 in the S&P 500 (SPX), starting at the same time as the Admired strategy.

The chart below compares the value of the Admired portfolio to the value of the Index portfolio since 1983. The annual return on the Admired portfolio was 13.91%, compared to 11.45% for the Index portfolio. Compounded over 35 years, $1,000 invested in the S&P 500 in 1983 would have grown to $44,498 by the end of 2017, while $1,000 invested in the Admired portfolio would be worth more than twice as much: $95,562.

The most-admired stocks did better than the broad U.S. market, evidently because the Fortune survey captures intangible factors that investors do not take into account fully. Information about which companies possess these most-admired traits was useful because the traits were specified in advance, before the companies were selected. The stock performance was measured after the companies had been selected, instead of selecting companies based on their stock performance.

It is unlikely that the above-average stock performance of the most-admired companies is some sort of risk premium since the companies selected as America’s most admired are large and financially sound, and their stocks are likely to be viewed by investors as safe. By the usual statistical measures, they are safer. Nor is the difference in returns due to the extraordinary performance of a few companies. Nearly 60% of the Fortune stocks beat the S&P 500.

Legendary investor Philip Fisher advocated a system he called “scuttlebutt,” which involves talking to a company’s managers, employees, customers, suppliers, and knowledgeable people in the industry in order to identify companies with good growth prospects. Perhaps Fisher was right: the way to beat the market is to focus on scuttlebutt — intangibles that don’t show up in a company’s balance sheets — and Fortune magazine’s most-admired survey is the ultimate scuttlebutt.

The table below shows the Fortune top-10 Most Admired for 2018, in order from No. 1 Apple (AAPL)  to No. 10 JPMorgan Chase (JPM) along with several simple valuation metrics. (Disclaimer: I own all 10 of these stocks, in varying amounts.)

The dividend yield (D/P) plus an assumed long-run growth rate of dividends is a rough estimate of the shareholders’ long-run rate of return. The earnings yield (E/P) is an estimate of the shareholder’s inflation-adjusted rate of return. Returns on assets and return on equity are benchmarks for management effectiveness. Free-cash-flow is another useful statistic, but is omitted here because of sometimes substantial differences in how it is calculated.

In our current interest-rate environment, with long-term Treasury rates at around 3%, and inflation-adjusted Treasury rates at perhaps 1%, many of these top-10 most admired stocks look like admirable investments. If I had to pick just one, it would be Apple, though it was certainly even more attractive 22 months ago, with a 2.28% dividend yield, 8.33% earnings yield, and long-term Treasury rates below 2%.

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