The Most Admired Companies Beat the Market

Do great companies make great investments? I'm sure you've heard that question before. Hey, we've even wondered that ourselves.

Detractors are quick to point out that great companies that produce great products aren't always fairly valued in the stock market. Last year, for instance, Starbucks (NASDAQ:SBUX) traded with a P/E ratio greater than 50 -- which is high, even by Starbucks' standards. Growth hasn't matched analyst expectations recently, and the stock is down 20% in four short months.

Despite periods of overvaluation, a recent study (link opens a PDF file) by Jeff Anderson and Gary Smith from Pomona College shows that the market's most-admired companies -- like Starbucks -- do in fact have a rich history of outperformance.

The returns are in
Anderson and Smith analyzed the returns of Fortune's list of the 10 most-admired companies from 1983 to 2004. They found that a portfolio of these stocks outperformed the S&P 500 by "a substantial and statistically significant margin."

These results are surprising. Financial theory would predict that large, popular companies would be fairly valued by the market. Even the authors admit that they have no compelling explanation for this phenomenon. They close their paper by wondering if beating the market might depend on intangibles that don't show up in the financial statements.

Stocks like these
In order to consider the type of companies we're talking about, I've included Fortune's top 10 admired companies for 2007. Remember that the study we've been considering only went through 2004. The following are not formal recommendations.

A radical strategy
A stock's P/E ratio or other multiple should not solely drive your investment decision. Fool co-founders and Motley Fool Stock Advisor analysts David and Tom Gardner believe that the key to outperforming the market is to focus on outstanding businesses. Sound management, sustainable growth rates, and a solid moat are what lead to great returns. (Not coincidentally, these are attributes found in Fortune's most admired companies.)

For example, David Gardner recommended FedEx to his Stock Advisor members in February 2003. FedEx was trading at a relatively high P/E and had been selected as one of the most-admired companies in America that year. When Tom asked his brother if this might be a great company with an overpriced stock, David responded by saying, "You gotta pay to play. I only wish I had purchased this stock when it looked expensive a decade ago!" FedEx is now up more than 96% since his recommendation in 2003.

The returns don't lie
This is not to suggest that you should blindly buy "admired" companies. Rather, it's a reminder that in your investing, you should be focused on businesses, not stocks. As professors Anderson and Smith show, it's a strategy that can lead you to long-term success.

That same strategy has fueled our Stock Advisor service. Since inception nearly five years ago (April 2002), David and Tom's recommendations are beating the market by more than 35 percentage points. You can see their most recent stock selections, as well as their top five companies for new money, with a 30-day free trial. There is no obligation to subscribe, so click here to get started.

John Reeves owns shares of Johnson & Johnson and Berkshire Hathaway. He likes all of the top 10 admired companies, but thinks he wouldn't like any of the top 10 admired celebrities. Starbucks, Dell, and FedEx are Stock Advisor recommendations. Dell, Berkshire Hathaway, and Microsoft are Inside Value selections. Johnson & Johnson is an Income Investor pick. The Fool has a disclosure policy.