On Tuesday, October 22, 2019, DePaul University’s department of finance hosted the second annual lecture in honor of AAII’s founder James B. Cloonan, Ph.D. Chicago area AAII members and DePaul students and professors gathered to hear Ravi Jagannathan, CME Group/John F. Sandner Chair of Finance from the Kellogg School of Management at Northwestern University, discuss his research on “A Market-Based Measure of Firm Quality.”

Jagannathan’s talk focused on how Warren Buffett’s investment style involves, among other things, buying good companies at fair prices. He developed a methodology for identifying good companies based on Buffett’s insight, “It’s only when the tide goes out that you discover who’s been swimming naked.”

Each year Jagannathan ranks firms within an industry based on their return during the worst month in that year after controlling for their size. Good firms are those in the top quintile. He finds that good firms identified in this manner are favorable along other dimensions as well. They are more profitable and have stronger balance sheets. Further, Jagannathan has found that a strategy that takes a long position in top quintile firms and a short position in bottom quintile firms earns superior risk-adjusted returns in excess of the risk-free rate: 3% to 5% per year on average, depending on the nature of risk adjustment.

When we asked Jagannathan what lessons or insights from his work would be helpful to individual investors building their portfolios, he told us the following:

“Identifying good companies in good businesses that are fairly priced for investment purposes is not an easy task. An attribute of good companies is that they tend to lose less than other firms in their industry peer group during sharp drawdowns. In this sense they are less risky even though they may be riskier when measured using the standard deviation of their returns. For example, Berkshire Hathaway did better than the portfolio of all firms in the financial sector 80% of the time, and the all stocks market portfolio 76% of the time, using these criteria during 1967–2018. However, Berkshire Hathaway’s monthly returns had a standard deviation of 6.73%, which was higher than the 5.34% for the finance industry portfolio and 4.26% for the market portfolio. This observation can be used to make a shortlist of potentially good companies for more detailed analysis and companies to avoid.”

Jagannathan is co-director of the Financial Institutions and Markets Research Center at the Kellogg School. He has previously held positions as Piper Jaffray Professor of Finance and associate professor of finance at the University of Minnesota’s Carlson School of Management, assistant professor of finance at Northwestern University’s Kellogg School and as a distinguished visiting professor at the Hong Kong University of Science and Technology.

Jagannathan received a Ph.D. in financial economics and an M.S. in financial economics from Carnegie Mellon University, an MBA from the Indian Institute of Management at Ahmedabad and a B.E. in mechanical engineering from the University of Madras. His Ph.D. dissertation received the Alexander Henderson award for excellence in economics.