Despised Companies Provide Better Returns: Should You Buy These 5 Stocks?

There is a new school of thought making the rounds in investment circles that goes something like this: it actually pays to be a company that people just love to hate. The logic here is that stocks of companies with awful customer service records, such as Time Warner Cable, tend to outperform stocks of companies with impeccable service records, such as Daimler Chrysler, maker of the iconic Mercedes-Benz model. Time Warner shares, despite taking a lot of flak on concerns of the company's terrible customer service record, gained 39% in 2013 and 450% over the last five years. This implies that they performed 50% better than the S&P 500 last year.

In that case, it seems like it would be a good idea to invest in the companies that Wall Street rates as America's most-hated. The "winner" is McDonald's (MCD 0.25%), followed by Abercrombie & Fitch (ANF -0.04%), Electronics Arts (EA 1.17%), Sears Holdings (SHLDQ), and Dish Network (DISH). Wal-Mart, JPMorgan Chase, Lululemon, BlackBerry, and J.C. Penney round out the top 10.

The American Customer Satisfaction Index rated 190 major American brands for customer satisfaction on a 100-point scale. Mercedes-Benz came out on top with a score of 88. Those on the other end included airlines, banks, and cable & Internet service providers. The list was then filtered to include only publicly traded companies.

The results are nothing short of shocking. What they basically say is that customer service scores have little relevance to a companies' stock market returns. For a bit more clarity, we can add a regression line that clearly outlines the general trend:

The trend is clearly downwards, suggesting that stocks of America's most-hated companies perform better than those of their beloved brethren. Specifically, there is no statistical relationship between a company's customer service score and its stock market returns.

The most astounding thing is that this dictum still rings true whether you take a big or small sample. Here is how the best and worst-rated companies performed in 2013.

What's more intriguing is that the most hated companies have the best returns. The worst 10 companies are the companies at the very bottom of the customer service score. This bunch sports the best stock returns by far, more than double that of the 10 best-loved companies. The best 10 companies, on the other hand, sport the best average customer service score but have the lowest returns.

Why the study can be misleading
It's difficult to argue with hard facts, especially when they are backed by the results of a scientifically conducted study. Those numbers are just too telling, and the fact that the trend repeats itself with alarming alacrity for both small and large samples says that this is not a fluke. So, should we conclude that investors should actively seek out stocks of companies with bad customer-service records since they look like the best bet for decent returns? Well, the short answer to that question is no, and yes. Let me explain.

The biggest reason stocks of companies with excellent customer service records routinely lag their counterparts with far worse records is quite simple. These stocks are well-known to most investors, and their excellent records are out there for all to see. The result? Investors usually end up bidding up their prices, many times excessively so. A good case in point is Lululemon, before its tragic sell-off late last year. Lululemon, like its peer Under Armour, were viewed as growth stocks in the sports apparel industry. Both stocks commanded stratospheric valuations compared to their mature counterparts Nike and Adidas—almost double their forward P/E ratios.

Lululemon quickly fell out of favor with investors after a series of calamitous events, beginning with its supply chain problems and a massive recall of its yoga pants (which was an unmitigated disaster.) Just when investors were beginning to forget the company's shortcomings, its management provided the final straw by lowering revenue and earnings guidance early this year. Investors were spooked. Maybe the company was no longer a growth story anymore. A huge sell-off ensued. Today, Lululemon sports a forward P/E very much in line with mature Nike's.

Apart from these latest mis-steps, however, Lululemon has had an impeccable record. Many people will of course not remember this, but its growth rate outperformed Under Armor for several years. You can therefore argue that investors overreacted, and Lulu could very well be grossly undervalued. Its stock is therefore quite likely to see substantial gains over the next 12 to 18 months.

The same goes for McDonald's. The company was for a long time a stellar stock, delivering steady and consistent returns. However, the advent of the fast-casual eatery theme, pioneered and championed by Chipotle Mexican Grill and others, has placed it under intense pressure. More people nowadays want to eat healthy, and McDonald's fare just doesn't cut it for them. That's why the giant fast-food chain is growing slower than its peers, hence the lower valuation.

Sears Holdings is viewed by most investors as a good asset play, rather than a good turnaround bet. The firm's retail outlets are not showing any convincing signs of a turnaround coming anytime soon. J.C. Penney is a better bet than Sears in this respect, since it's showing serious intent on revitalizing the flagging fortunes of its retail stores.

Foolish bottom line
Yes, the list of America's most hated companies can serve as a nice place to find companies that are undervalued on the basis of their less-than-ringing customer service records. Investing blindly in the top-10 companies with the worst service records might work out in the short-term, but it will be foolhardy for a long-term investor to fail to do due diligence. Investors need to establish whether the issues that are dogging the companies are ephemeral, or if they represent long-term industry trends that are likely to bring the companies to their knees.