Why Bad Things Happen to Great Companies

Here are a few blindingly obvious observations: Naomi Campbell is beautiful, Peyton Manning can throw a football, and Jack Nicholson can act. Oh, and Coca-Cola (NYSE:KO) owns a formidable eponymous brand that has produced a long history of persistent, predicable growth.

I suppose I could add that two plus two equal four, and the sun rises in the east, but I think the point is understood, especially regarding Coca-Cola. When analysts and advisors discuss high-quality companies, Coca-Cola is sure to permeate the conversation.

A Coke and a smile
And why shouldn't it? Coke is as dependable at delivering operating efficiency and revenue and earnings growth as the Chicago Cubs are at delivering September disappointment.

In fiscal-year 1999, Coke posted net income of $2.4 billion; in 2008, it posted net income of $5.8 billion. Impressive, considering revenue grew to $31.9 billion from $19.3 billion over the same period. For dividend lovers (and I'm one), annual payout per share increased more than twofold to $1.52 from $0.64. All the while, management delivered a return on equity that hovered around 30%.

Therefore, it's not surprising that Coke is a favorite among quality-craving investors. When a company strings together preternatural growth measured in decades, investors are sure to notice. What's more, Coke's long record of success not only instills a sense of security, but provides an anchor for estimating the future: Extrapolation is far easier to rationalize when analyzing companies with linear-growth histories (which is why earnings management will always be an issue in stock analysis) than ones with erratic-growth histories. 

While the future value of strong and stable companies can be estimated with a higher degree of confidence and ease, these very factors can result in overpricing that becomes either unattractive or leads to future under performance. Stocks like Coke, which combine resistance to depressions with good growth records, tend to become so popular that they sell at excessive multiples of their past earnings and of reasonable projections of expected earnings and dividends.

I can't say if that's Coke's case. I could even argue Coke is reasonably priced based on its 17 forward price to earnings multiple. But I can say that investors are cognizant of Coke's position in the beverage world, and common knowledge can be a formidable barrier to investing success: Indeed, if you had bought Coke a decade ago, you'd be about where you had started. In fact, you'd be a little less than where you had started, as Coke is trading below January 2000 levels.

To be fair, Coke has outperformed the S&P 500 over the past decade, which isn't saying much, considering the S&P 500 is down 22%. (By the way, you can't spend relative return.)

Other perceived high-quality companies have also been middling performers in absolute terms for the same reason Coke has -- popularity. The following table provides some insight to how investors would have fared with a sample portfolio of high-quality companies over the past decade.

Stability and instability
Where a trend exists, everyone who is interested knows about it, creating a dilemma: If you believe the trend will continue and know that most other investors following the stock hold similar beliefs, then even being correct offers little opportunity.

Worse, what if the trend reverses? Two years ago, I would have shoe-horned Pfizer and General Electric onto this list. A decade back, I would have included a public utility, which used to be exemplars of stability and predictability -- that is, until Enron roiled the waters. Life insurance companies, food processing companies, medical suppliers, distillers, and tobacco companies all used to be paragons of predictability. And like public utilities, the same can't be said today.

In short, high-quality companies don't equate to outstanding investments, and not just because of common knowledge. Stability itself can create instability. Economist Hyman Minksy explicated the phenomenon on a macro level in his "Financial Instability Hypothesis." Minsky writes, "The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."

I believe the same forces hold true for individual companies -- stable relations lead to unstable relations. After all, success changes the dynamic for future success; competition and the law of diminishing returns are powerful foes of unfettered prosperity.