Close

    The Folly of Crowd-Following: Popular Stocks=Unpopular Returns

    by Edwin D. Everett

    Moderating energy prices and inflation measures have lifted investors’ spirits of late. But lest this brighter outlook cloud investors’ judgment too much, we offer a cautionary tale of what enthusiasm can do to returns. This article focuses on the perils of following the crowd into super-popular stocks.

    For as sure as fear and greed drive the stock market, when it comes to popular stocks, in particular, greed inevitably gets the upper hand. And investors end up with a losing hand.

    The reasoning starts out logically enough—the stock of a company that is growing is worth a premium over one that is not: the more rapid the growth, the greater the premium should be. But almost without exception the fastest-growing companies get bid up to unrealistic and unsustainable levels by unbridled investor enthusiasm. Greed, wishful thinking, and naive extrapolation of past results push valuations far above anything justified by realistic, sustainable earnings growth. With an impossibly high bar for management to attain, disappointment is the typical end result. This is how today’s highly popular stocks usually end up tomorrow’s losers—sometimes spectacularly so.

    We have carried out a study for the past 23 years that tracks the subsequent performance of the stock that is most popular on the New York Stock Exchange each spring. We equate popularity with the price-earnings ratio and select the security with the highest price-earnings ratio as of the end of April (based on trailing earnings) and measure the stock’s performance over the following year.

    The sad story this study tells (see Table 1) is that purchasing each year’s most popular stock and holding it to the present would leave the investor dreadfully behind the market. Typically, the most popular stock has carried a multiple some three times greater than the market (defined as the S&P 500), yet as the table shows, this “portfolio” of market favorites has earned an average return that is less than one-third the S&P 500.

    Table 1. How Popular Stocks Fared
    April Highest P/E Stock Original P/E Ratio Percentage Change
    Original Year to 5/05
    Stock
    (X)
    S&P 500
    (X)
    Stock
    (%)
    S&P 500
    (%)
    1982 NBI, Inc. 24 7 -100 937
    1983 Cullinane* 44 12 320 658
    1984 Advanced Micro Devices 35 12 0 630
    1985 Cullinet* 37 11 391 541
    1986 Marion Labs** 53 16 238 385
    1987 Marion Labs** 68 21 55 296
    1988 Rollins Environmental*** 34 15 na 348
    1989 Century Telephone 34 12 181 293
    1990 Total System Services 47 13 878 241
    1991 U.S. Surgical? 63 15 -13 209
    1992 U.S. Surgical? 70 18 -57 186
    1993 Home Depot 58 18 259 162
    1994 Ann Taylor Stores 51 20 56 162
    1995 Corrections Corp. 57 15 -71 130
    1996 Checkpoint Systems 61 17 -36 78
    1997 Cardinal Health 41 19 -3 53
    1998 Coca-Cola Enterprises 95 28 -46 3
    1999 DBT Online?? 97 28 -55 -12
    2000 Cisco Systems 138 29 -75 -21
    2001 Allergan 49 23 -4 -8
    2002 Krispy Kreme 85 24 -84 8
    2003 Krispy Kreme 58 19 -82 20
    2004 Boston Scientific 61 19 -27 5
      Average 59 18 75 231

    For purposes of the study, candidates for the most popular award must have had earnings in the first place, and those profits had to have shown some reasonable upward progression. That is, earnings could not be cyclically depressed or grossly distorted by special charges or extraordinary items, both of which circumstances inflate the price-earnings ratio by deflating earnings, the denominator in the equation. Historically, we have focused on New York Stock Exchange stocks even though issues on the NASDAQ have at times been more “popular.” (The NASDAQ sported a price-earnings ratio of 145 at its peak!) The problem in measuring popularity using NASDAQ companies is that too many of them earn little or no profits and therefore provide no good common benchmark for assessing investor enthusiasm. The New York Stock Exchange is a more homogenous and conservative group of companies and makes for a more consistent study.

    We use the S&P 500 as proxy for the valuation of the market, even though the consistency of this index has become less reliable in recent years. Post-bubble-era accounting practices are considerably stricter following that period’s abuses, and changes in the component companies of the S&P index itself have been more frequent in recent years.

    Regardless of how exact S&P 500 earnings figures are (and the price-earnings ratios calculated from them), it should be obvious that paying a high valuation on a stock will likely limit its ultimate return. What is surprising is just how significant those limits can be and how badly the market favorites have performed.

    As the table shows, the cumulative average appreciation of the study’s 23 stocks amounted to just 32% of the return one could have earned by investing equal amounts in theS&P 500 each April since the study began. Some 14 stocks have posted negative returns, with two effectively going to zero—NBI Inc., now a penny stock, and Rollins Environmental, which went bankrupt.

    More than half the stocks lagged the market by more than 100%. And just three stocks out of 23 did better than the S&P 500 over the respective time periods. That puts the odds against a super-popular stock paying off at nearly eight to one.

    This disastrous record has come regardless of the market’s relative value or cyclical phase. The price-earnings ratio on the S&P 500 has ranged from a relatively cheap level of seven in 1982, to a peak of 29 in 2000.

    Why do highly popular stocks fail?

    It’s a combination of unrealistic or ultimately unachievable expectations with too-high valuations.

    Perfection Rarely Lasts

    It is natural for investors to get excited when markets for a company’s products offer seemingly limitless growth opportunities. But growth is rarely ever limitless in the long run, and in the short run business developments can upset any or all optimistic expectations. New technology or more competitive business models can quickly derail growth. Exciting new markets might also fail to grow as rapidly and profitably as first thought.

    By way of an example, advances in technology cut short the moment of glory for our study’s first entry (the 1982 most popular stock), NBI Inc., which was No. 2 behind Wang Computers (remember Wang Computers?!) in the rapidly growing market for word processors.

    The advent of the much more versatile personal computer effectively buried the word processor market, along with NBI (and Wang eventually, too). Today NBI manufactures glass, owns a hotel, and trades very far from the New York Stock Exchange.

    Meanwhile, Cullinane/Cullinet, the 1983 favorite, pioneered database management software for large, mainframe computers only to see its growth stall as minicomputers, and then PCs, supplanted the mainframe business. Fortuitously, Cullinane sold itself to Computer Associates, which until the year 2000 was itself a rapid grower and accounts for most of the Cullinane’s “performance” in the table.

    One company that couldn’t live up to its early hype was Corrections Corporation, the 1995 most popular stock. At the dawn of the Thatcher/Reagan era of deregulation, investors were euphoric over the prospects for privatized government operations and the first for-profit prison operator, Corrections Corporation, in particular.

    However, the glow on that stock soon faded as revenue growth failed to materialize.

    Donut-maker Krispy Kreme is the most recent classic case study in missed expectations and changed business conditions. Smart marketing, tremendous word-of-mouth reputation, a small starting base, and a “gotta have” product propelled Krispy Kreme’s earnings at a better than 50% compounded annual rate for its first four years as a public company. Success put the company on the cover of Fortune magazine, made its name the hottest brand in America, and sent the stock at times on a faster (if bumpier) ascent than its earnings. It made our Most Popular list two years in a row, 2002 and 2003.

    Then along came the Atkins diet craze—the high protein, low carbohydrate regimen that had no place for Krispy Kreme’s signature glazed donut with its 200 calories and 12 grams of fat. Kristy Kreme’s sales, earnings, and stock price went into free-fall. (Management compounded these problems by allegedly cooking more than just donuts. The company is now being investigated for financial irregularities by federal officials and the SEC and is going to have to restate some of those profits previously thought to be expanding so rapidly.)

    It can be argued the company’s star turn was based on nothing more than a food fad, and fads, by definition, fade away. (And as much as the FDA shuffles the composition of the food pyramid, donuts will never likely have a place in it.) After trading at an average price-earnings ratio of 57 during its heyday, Krispy Kreme stock now sports a price-earnings ratio of nine.

    There are three ways to strike out in the popularity game.

    Strike One: The Competition

    Often times, rapidly growing companies confound expectations because they stumble in the face of new competition. The very lucrative opportunity they are profiting from and that has whipped investors into a frenzy usually encourages new entrants to the field.

    These newcomers are often much larger and more powerful than the pioneers and come to the market with a better, second-generation product. If the newcomers don’t steal the top position from the early leader, they can put the brakes on the pioneer’s growth and squeeze its profit margins.

    Advanced Micro Devices, the 1984 favorite, faced just such a dogfight when Intel Corp. and others trumped it in microprocessor chips at the dawn of the personal computer era. The fight for dominance in computer chips and microprocessors has continued to this day, and Advanced Micro Devices has never gained the advantage.

    U.S. Surgical (the favorite for 1991 and 1992) fought a similar battle for the laparoscopic (non-invasive) surgical instruments market, where it had pioneered both technology and techniques. Then, Johnson & Johnson took a shine to the business, spent a lot of money to develop products, and ultimately took the No. 1 spot in the market from U.S. Surgical after just a few years. U. S. Surgical continued the fight until 1998, at which time it sold out to Tyco.

    Ironically, Johnson & Johnson is one of the spoilers for the latest addition to our stock study, Boston Scientific. As was the case with U.S. Surgical and the non-invasive surgical instruments market, Johnson & Johnson is now a major competitor in Boston Scientific’s bailiwick— cardiovascular stents, mesh metal tubes inserted in arteries to relieve blockage.

    Although Johnson & Johnson was first out of the gate with the next-generation, drug-coated versions of stents, Boston Scientific’s offering has been very well received and has accounted for nearly all of the company’s recent growth (despite it’s providing a broad array of other medical devices). Last year, however, defects prompted a product recall, which clipped sales and earnings.

    Boston Scientific’s shares are off 31% since last year, perhaps in part because the market recognizes things may get more difficult as two more new stent competitors join the market in 2006 and after.

    Strike Two: Management

    Business conditions change, and new technology and competition disrupt established markets as a matter of course in our economic system. It is up to management to respond to new conditions to maintain leading market positions, keep rapid growth going, and not dash investors’ high expectations.

    Sometimes success is simply being in the right place at the right time—it’s hard not to mistake luck for ability when business is on the boil. It is only when conditions change and the place or time is no longer “right” that investors can judge the capability of management. Success endures for those corporate leaders who have the foresight to see changes coming and the flexibility to adapt to them.

    Executives at Home Depot, the 1993 most popular stock, for example, had to adapt to less robust earnings growth after a long period of 20%+ annual profit expansion as it tapped into the housing boom and rolled over local hardware stores. The stock also performed well enough to keep it among the few in our study to be ahead of the S&P 500.

    However, Home Depot reached a saturation point in adding new stores at the same time it was grappling with just how to manage such a large business. Its subsequent decision to centralize authority backfired because it squelched the entrepreneurial spark at the individual store level that had helped propel its corporate success. Home Depot also faced new head-to-head competition from Lowe’s.

    The company responded to these changes by revamping its stores and product lines, pushing into new, more urban locations, and differentiating its services for professionals. It has regained some ground, and last year its profits expanded 20%. Growth is expected to moderate longer term, however, as it still faces the law of large numbers and it loses the tailwind of low/declining interest rates.

    Some managements fail to adapt and their companies’ (and stock prices) fall from grace because of poor execution. For example, Checkpoint Systems (the 1996 favorite) which makes electronic tagging systems and other retail security and merchandise tracking equipment, overexpanded and had trouble integrating acquisitions following its rise to prominence. These missteps caused margins to decline, and Checkpoint got into trouble for some of its revenue recognition practices. Earnings have been growing again in the past few years, but not at the breakneck pace of the stock’s heyday.

    This last point is important: There are very few second acts in American business. And even if companies can recover from missteps or shifting industry conditions, they seldom return to the rates of growth that made their stock super popular.

    Strike Three: High Valuations

    With it being so hard for companies to stay at the very top, the amount investors pay for growth remains ever more critical. When companies are “priced to perfection,” even if investors’ expectations are reasonable, there is only one way to go, and that is down. The high wire that management walks is made that much more difficult to navigate by investor exuberance, which often drives up both expectations and valuations to unsupportable levels.

    It should be obvious that paying very high prices for rapidly growing companies is a recipe for disaster when companies can’t meet those expectations. The proof in the pudding is in the table. High valuations—and in the case of this study the highest valuation—leave no room for error and turn the strategy of “buy low, sell high” into “buy high, hope to sell higher.”

    And just as it is difficult for companies to recover operationally and enjoy a second act, it is even harder, if not impossible, for stocks to regain their super-premium status after getting knocked out of the stratosphere. 

    Two of the exceptions on our list that remain ahead of the S&P 500 experienced extended periods of underperformance:

  • Total System Services lagged the S&P for three years after its debut on the list in 1990; and
  • Home Depot trailed for five years following its first appearance and has lagged for the past five years.

    Thus, investors have needed considerable patience to get the payoff from these companies’ business success—a patience they seemingly weren’t willing to exercise in waiting for a better time and price to buy the stock in the first place.

    Conclusion

    Greed is partly what makes an entrepreneur dream big. It also is what drives investor emotion and stock values to extremes. However, when it comes to stock prices, emotion only rules in the short run—business fundamentals and the progress and sustainability of earnings determine long-run success.

    And as we’ve seen, rapid, sustainable growth is hard to achieve. That is why it really does matter what you pay for earnings, and why so often super-popular stocks end up being such unrewarding investments.

    The evidence of this study suggests investors would be far better off leaving the hottest of stocks out of their portfolios and putting a more sensible focus on both business fundamentals and valuations instead.


    Edwin D. Everett, CFA, is a portfolio manager in Babson Capital Management’s Private Wealth Management group and managing editor of the Babson Staff Letter. Babson Capital manages more than $90 billion for institutional and retail investors in the U.S. and abroad, as well as high net worth individuals and family offices. The firm offers a wide range of relative return, absolute return, co-investing, financing and customized mandates utilizing equity, fixed-income and derivative instruments. Based in Cambridge and Springfield, Massachusetts, the firm has six additional offices in the U.S. and an indirect subsidiary, Babson Capital Europe Limited, in London. Babson Capital is a member of the MassMutual Financial Group (www.babsoncapital.com).

    This article is reprinted with permission from the May 27, 2005, issue of The Babson Staff Letter.


→ Edwin D. Everett