Investing in America’s Most Admired\u00a0Companies<\/h6>\n

Regular readers know that I\u00a0believe in\u00a0building a diversified investment portfolio using index funds.\u00a0However, I know that there are\u00a0some investors who\u00a0think they can do better with a more concentrated strategy.<\/p>\n

Many individual investors I have spoken to\u00a0prefer to make concentrated bets on individual stocks, and some even have a large portion of their net worth invested in the stock of their employer!<\/p>\n

Needless to say, I think investing a sizable percentage of your total wealth in\u00a0your employer’s stock is a terrible investment strategy. Not only does it result in a poorly diversified portfolio, but in a worst case scenario you could\u00a0find yourself\u00a0out of a job with a worthless portfolio….remember Enron and Worldcom?<\/p>\n

Whenever I make the case for greater diversification, the response I get it always the same: “Yes, but it’s a great company!”.\u00a0\u00a0 In other words,\u00a0these\u00a0investors\u00a0acknowledge that diversification may be a good idea for other people, but they don’t\u00a0believe that\u00a0it applies in the case of their company.<\/p>\n

Testing a Simple Investment Strategy<\/h6>\n

In this post, I look at the risk and return\u00a0for a simple strategy that makes concentrated investments in “great companies”.\u00a0\u00a0 Each calendar year the strategy invests 100% of total wealth\u00a0in\u00a0the most admired company in America.\u00a0 I’ve chosen the most admired company for each year based on a survey conducted by Fortune Magazine<\/a>.<\/p>\n

Fortune has published the list of\u00a0America’s most admired companies<\/a> every year since 1983.\u00a0 In the table below,\u00a0I’ve\u00a0listed the\u00a0most admired\u00a0company for each year and the total return (including dividends)\u00a0that the company’s stock earned in the year that it was voted to be\u00a0#1.\u00a0 I’ve also\u00a0listed the S&P500 returns for each year.<\/p>\n

<\/a><\/a><\/p>\n

The green cell background shows the option with the higher\u00a012-month return, and the red cell background shows the option with the lower 12-month return.<\/p>\n

The final two columns\u00a0show how $1000 would have grown under two investment scenarios.\u00a0 In the first scenario, all funds are invested in the year’s most admired company (no taxes or transaction costs are assumed).\u00a0 In the second scenario, all funds are invested in the S&P500.<\/p>\n

The results of the analysis show that the S&P500 index outperformed the “Most Admired Company” strategy even\u00a0without accounting for trading costs or taxes.\u00a0 The $1000 invested in the S&P500 grew to $13,153, and the $1000 invested in the Most Admired Company grew to $11,319.\u00a0The S&P500 portfolio outperformed even though\u00a0the arithmetic average return is higher for the most admired company strategy (for a discussion of why arithmetic and geometric returns can differ see here<\/a>).<\/p>\n

The individual company strategy is also much more risky.\u00a0 The standard deviation of the annual returns is considerably higher.\u00a0 Investors in this strategy saw larger fluctuations in the value of their portfolio, but the strategy did not provide any additional return to compensate for the\u00a0increase in\u00a0risk.<\/p>\n

Note that 1994 and 1995 are\u00a0shown in the table, but they are omitted from the\u00a0analysis since Rubbermaid was acquired by Newell in 1999, and I haven’t been able to find the necessary historical\u00a0returns for Rubbermaid as a stand alone company.<\/p>\n

Longer Term Returns for #1 Companies<\/h6>\n

Many investors hold onto company stock for many years, so I’ve also looked at total returns for the next 5-yrs for each most admired company and for the S&P500.\u00a0 The results are shown in the following table.<\/p>\n

<\/a><\/p>\n

In 13 out of 22 cases, the S&P500 outperformed the individual company. \u00a0The total return over the 5-yr period was also higher on average for the S&P500, and the variance in returns was lower.<\/p>\n

Conclusion<\/h6>\n

This analysis shows that a diversified portfolio often outperforms a simple “great company” strategy. \u00a0Over both the 1-yr and 5-yr time frames, the diversified portfolio outperformed more often than not and had lower risk. \u00a0It is possible that a more sophisticated strategy might yield some better results, but investors should be careful about any investment philosophy or strategy which cannot stand up to careful analysis.<\/p>\n

Additional Information:<\/strong><\/p>\n

The returns used in this analysis were calculated using the adjusted historical prices from Yahoo! Finance, and the Google Docs spreadsheet used for generating the tables in this post is available here<\/a>.<\/p>\n

Update: <\/em><\/strong>DIY Investor <\/a>suggests taking a look at the performance of \u00a0the most admired company strategy using the returns from the year prior to the year they were selected as “most admired”. <\/em><\/p>\n

I tried this, and, as you might suspect, it made a dramatic difference. If we use the prior year returns, the $1000 initial investment would have grown to $545,047 (before taxes) when investing in the “most admired” firms, and it would have grown to only $19,981 with the S&P500 (the shift of one year means that I used a different range of dates so the S&P500 return doesn’t match the return shown in the trailing 1-yr analysis). \u00a0Of course this backward looking strategy can’t be implemented in practice, and this dramatic difference in result just highlights the old saying that “past performance does not guarantee future results”. \u00a0The spreadsheet for the prior 1yr analysis is available here<\/a>. <\/em><\/p>\n

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