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Better Than the Best

Here at The Motley Fool, we have long advocated investing in quality businesses. There are plenty of reasons, the most persuasive being that master investors like Buffett and Lynch made giant fortunes by paying up for some of America's premier companies.

One widely recognized and easily digested measurement of corporate quality is the annual Fortune list of "Most Admired" companies, which could be an easy and valuable investing tool. Academic research shows that money invested in the Fortune most-admired companies would have outperformed the S&P 500 (PDF file) by a tidy margin between 1983 and 2004.

That seems to suggest it'd be in your best interests to bet on these companies yourself, except for one little detail: The "Least Admired" companies provided even better returns.

Come again?
Investing in the reputation dregs could turn out to be more lucrative than buying the best, by a score of 17.8% to 15.4% (averaged, annualized returns). How can this be? Well, an article at Fortune explains what has always been obvious to me. Investors tend to shun reviled companies, beating down their shares past a rational valuation. Admired companies tend to carry higher price tags, making it tougher for the stock to pay off for investors (PDF file).

The latest list provides a great example of a company that hit the lists only after its success -- and oversized stock returns. Apple (Nasdaq: AAPL  ) is a current favorite, but where was it back in 2002, back when the stock was cheap?

The dangers of buying the best are illustrated by other examples of well-regarded companies with poor returns. Early '80s admirees such as IBM (NYSE: IBM  ) and Kodak (NYSE: EK  ) gave investors a dismal decade. And the 2001 "innovation" winner was Enron, which also scored No. 2 in "quality of management!" Fortunately, the admirees list has gotten major outperformance from firms like Merck (NYSE: MRK  ) , Johnson & Johnson (NYSE: JNJ  ) , and Wal-Mart (NYSE: WMT  ) .

And what of the loathed? It's also a mixed bag. To stick with the class of 2001, punching bag J.C. Penney (NYSE: JCP  ) made a major comeback. Others, like Dillard's, have provided only moderate returns. Still others, like LTV, sank onto the pink sheets. That's why Anginer, Fisher, and Statman, the authors of the latter study, caution that, over certain time periods, the "admired" companies performed much better than the despised.

This ought to warn you against running out to fill your portfolio with everything the market loathes. Some companies are hated for very good reasons. Many of the companies least admired for 2007, for instance, are already in bankruptcy. (Though I wonder what a portfolio of hated, non-bankruptcy-seeking Fortune companies would have returned.)

A modest proposal
As an investor, you don't have to choose one strategy over the other. You can pick from either side of the admiration ledger, as do my colleagues at Motley Fool Inside Value. Cheap-stock guru Philip Durell is happy to choose admired companies, so long as the price is right. But given the great likelihood of pricing inefficiencies in the market's seemy underbelly, the Inside Value team spends a great deal of time checking out firms with tarnished reputations.

And it looks like the dregs of the Fortune list should provide some new ideas, since that research demonstrates what many of us value investors already know from watching our portfolios: When it comes to stocks, good can be great. But bad can be even better.

A free 30-day trial of Inside Value is just a click away.

At the time of publication, Seth Jayson had shares of Johnson & Johnson, but no positions in any other company mentioned here. Johnson & Johnson is a Motley Fool Income Investor recommendation. Wal-Mart is an Inside Value selection. Fool rules are here.

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