Why the most admired businesses often make the most disappointing investments.

The Paradox of Popularity

At first glance, investing seems like it should be straightforward: identify a great company, buy its shares, and profit from its success. This logic, popularized by figures like Peter Lynch who advocated for 'buying what you know,' suggests that household names with robust profits and admired services are the safest path to wealth. However, this intuitive approach overlooks the fundamental mechanics of asset pricing. In the stock market, a 'good company' and a 'good investment' are often two very different things.

The central problem is that excellence is rarely a secret. When a company has a dominant brand, a wide competitive moat, or a stellar reputation, those qualities are already baked into the share price. Because more investors want to own these glamorous businesses, their prices are bid up. In financial terms, higher prices for a given set of future cash flows mathematically lead to lower expected returns. This phenomenon creates a 'good company fallacy' that can lead even sophisticated investors to overpay for quality while shunning the very stocks likely to deliver superior performance.

The Data of Disdain

Extensive research confirms that popularity is a drag on performance. In the study 'Popularity: A Bridge Between Classical and Behavioral Finance,' researchers analyzed stocks based on brand value, competitive advantage, and reputation. Between 2000 and 2017, they found a consistent negative relationship between brand value and returns. A dollar invested in the least popular stocks dramatically outperformed the most popular ones. Similarly, companies with no competitive moat beat those with the widest moats by a wide margin over a fifteen-year period.

Reputation follows a similar trajectory. Companies with the best reputations trailed those with the worst by over five percent per year. This isn't just a recent fluke; data spanning back to the 1980s shows that 'admired' companies consistently underperform 'spurned' ones. When a company’s name elicits a 'halo' of positive sentiment, investors are misled into believing the stock offers high future returns with low risk—a combination that is fundamentally unrealistic in a functional market.

The Trap of Extrapolation

Why do we keep falling for glamour stocks? Much of it comes down to a psychological error known as extrapolation. Investors tend to look at a company’s recent explosive growth and assume it will continue forever. This 'growth opportunities bias' is prevalent even among professional sell-side analysts. By assuming that tech giants or innovative disruptors can maintain exceptional growth indefinitely, investors justify paying astronomical price multiples.

History shows that growth eventually slows and valuations converge. As a 'good' company matures, its earnings growth inevitably declines while its cost of capital increases. This convergence is what explains the long-term underperformance of glamorous stocks relative to their shunned peers. While a few companies may defy the odds for a decade—as we have seen with certain U.S. tech giants—basing an entire investment strategy on these 'unexpected' returns is a gamble against the historical norm.

Risk, Skewness, and the Lottery Effect

There is also a structural reason why 'bad' companies often provide better returns: they are riskier. Stocks that perform poorly during market crashes—those with 'negative co-skewness'—command a risk premium. Investors require a higher expected return to compensate them for the pain of owning a business that might struggle during an economic downturn. Conversely, 'good' businesses like Amazon often hold up better during crashes, making them more comfortable to own, which in turn lowers the return premium they offer.

Retail investors are particularly prone to 'lottery stocks'—investments with a high probability of poor returns but a tiny chance of an extreme payout, such as recent IPOs. These stocks often experience a 'first-day pop' driven by excitement and expected skewness, but they typically perform poorly over the long run. The desire for a big win leads investors to overpay for the dream, leaving them with an asset that has a high price and a low probability of success.

The Value of the Unloved

Ultimately, what matters for expected returns is the price you pay for future cash flows. All else being equal, a lower price indicates a higher expected return. This is why value stocks—companies that are often unglamorous, unpopular, or facing temporary hurdles—historically outperform. They are priced for failure, meaning any news that is 'less bad' than expected can send the stock higher. They are the 'bad companies' that make for good investments.

Successful investing requires the discipline to look past the narrative and focus on the math of expected returns. While it is psychologically difficult to buy companies that are unloved by consumers or criticized in the press, these are often the assets that reward investors for bearing risk. Expected returns are not a law of physics, but they are a robust model for the world. If you want the higher returns, you must be willing to own the companies that no one else wants to talk about at a dinner party.