September 14, 2014

Invest in What You Know to Beat the Market?

The "invest in what you know" mantra espoused by the great Peter Lynch sounds great. After all, we'd all rather buy companies that give us the warm fuzzies than put money into confusing or boring companies we don't understand. Just about everyone has a friend or relative who claims to have made a killing getting into Apple at the right time. They just knew it was going to be the investment of the decade. The iPod was a massive hit and many people would rather die than part with their iPhone. Or how about shoes? There are over 7 billion pairs of feet in the world! We all need to cover them with something...maybe I'll invest in Nike! Come to think of it, I like burgers, cartoons, driving, and shopping online, so I'd better add some McDonald's, Disney, Ford, and Amazon to my portfolio too.

Pan Am was a big brand...but a good investment?
I could go on and on like this. People naturally like to gravitate toward familiarity and it's more fun to own a bunch of companies that sell products you love. Never mind whether or not it's wise to mix up your emotions with your investments. After all, it's only your retirement that's on the line. And there's the risk of taking Peter Lynch's advice a little too literally. While getting inspiration for investing ideas from your day-to-day life, due diligence is still critical to any investing decision. I may buy a lot from Amazon, but does that mean I should buy its stock with a 500+ P/E ratio?

Anyway, I thought it would be fun to do a little backtest to approximate a "buy what you know" investment strategy (much more of an active approach compared to passive indexing). Interbrand values and ranks the Best Global Brands each year, and tracks corresponding changes in value from the previous year. Taking a sample of 20 of the top brands from this list seemed like a good way to simulate investing in what you know. My guess is that most Americans are familiar with just about every name on it. I picked everything from the top 20 that's currently listed on a U.S. stock exchange as a stand-alone entity, removing five companies including Samsung, Mercedes, BMW, Gillette (part of P&G), and Louis Vuitton. I dipped further down that list to add Honda, Pepsi, American Express, Nike, SAP, and UPS.

A sample hypothetical set of stocks chosen based on Interbrand's Best Global Brands list
To construct my sample portfolio, I assumed retail investors like myself would be more likely to go with more of an equal weighting approach. For example, Apple is valued at about $608 billion and a small company like The Gap (further down the top brands ranking) has a market cap a little over $19 billion. Sure, some folks might buy 32 times as much AAPL stock as GPS, but I suspect the average person might just put roughly equal amounts in many of the companies they're interested in. Google went public just over 10 years ago, so conveniently we have 10 years of data to look back at for each company on the list. I wanted to compare returns for this hypothetical portfolio against indexing with ETFs. I used an iShares large, mid, and small cap ETF for each market cap segment (IVV, IJH, and IWM: tied to the S&P 500, S&P 400, and Russell 2000 respectively). Next, I broke out the best brands portfolio a few ways. First, I equal weighted all 20 brands, the "Big Brands" line. Next, since AAPL has been somewhat of an outlier, I removed it to show the performance of the other 19 stocks. Lastly, I included returns for 17 of the most valuable brands removing Apple, Amazon, and Google. Back in 2004, the wounds from the dot-com bubble bursting were still fresh, so I thought it would be fun to look at how many of the older, more established brands performed without a few of the names many people would have probably assumed to be riskier. Let's take a look at the total returns, based on monthly adjusted close prices factoring in dividends and splits...

10-year returns for 2013 Best Global Brands vs IVV, IJH, and IWM

Impressive! If you had the foresight 10 years ago to buy-and-hold these 20 brands (including AAPL), your portfolio would have returned in excess of 400%! The indexes did well, large caps doubling during that time and small and mid caps doing even better. But the best brands crushed the index returns. Even when you remove three of the hottest stocks over the past decade, the remainder of the biggest brands still increase nearly 200%, tripling the original investment!

If we look at a shorter time period, just the past five years:

5-year returns for 2013 Best Global Brands vs IVV, IJH, and IWM

The story looks a little different here. Mid cap stocks (IJH) just about tied the performance of Interbrand's Best Global Brands from 2013, but the "buy what you know" strategy would still have beat a total stock market (large cap) indexing strategy during this time. Overall, it appears as if buying stocks based on what you know might be a pretty solid investment strategy. At best, these stocks would have crushed passive indexing over the past decade. At worst, over a shorter time frame, they mostly kept pace with the broader market. With Apple included, this set of companies matched S&P 400 mid cap returns and beat out large and small. Without Apple, this portfolio still outperformed large and small caps as a whole. And even if we remove Amazon and Google (two of the top performers), the remaining 17 companies just barely underperformed the S&P 500.

So is it all good news for the "buy what you know" strategy? Well, there are a few more things we need to consider. First, the above returns are based on the most valuable brands now (or in 2013 anyway). These brands are valuable now because of how they performed in recent years. And there's probably a bit of survivorship bias going on here. Were there brands that were in this list ten years ago that aren't there anymore? Do we have any brands in our hypothetical portfolio that more recently joined the list? Just about everyone was aware of Amazon and Google in the early 2000s, but Amazon had a pretty tough stretch after the market crashed, getting lumped in with companies like that imploded during that time. I also distinctly remember a lot of skepticism around Google going public at that time. It was far from certain the company would turn into the huge success it is today. As far as Apple goes, the iPod was just taking off. People loved the product, but most people likely couldn't predict Apple would enter the phone business, let alone the iPhone/iTunes ecosystem that would take off years later. Most of us were just getting excited about flip phones then!

Luckily, Interbrand has their Best Global Brands rankings posted for all the way back to 2000. Let's take a look at the 2004 rankings from 10 years ago. There are a lot of familiar faces in both lists, but a lot has changed in ten years:
  • Nokia was a top 10 brand in 2004, now it's #57
  • Dell was in the top 25, now #61
  • Marlboro was #10 back then - it's not even on the list now!
  • Sony dropped 26 spots, from #20 to #46
  • Samsung has climbed from #21 to #8, becoming an aspirational brand in its own right
  • Most big automakers and a lot of luxury brands are on both lists, shuffling around over the years
  • Most notably, Google was nowhere to be found in 2004 (it debuted at #38 in a year later, in 2005), and both Apple and Amazon were middle-of-the-pack at #43 and #66 respectively
  • For a more recent comparison, Facebook made its first appearance in 2012 at #69, jumping up to #52 in 2013.
In fact, Yahoo was considered a more valuable brand than Amazon back then, and although AOL had begun its decline in the rankings, it was still on the list. That being said, and since we didn't have a time machine or a crystal ball ten years ago, let's take another look at how the biggest brands' stocks from 2004 would have performed in comparison to our index ETFs. While the most valuable brands tend to be pretty enduring (13 of the top 20 are the same in 2004 and 2013, and 7 of the top 10 are identical), most of the differences are made up of companies that have had precipitous declines or rapid ascents.

Second hypothetical set of stocks chosen based on Interbrand's 2004 Best Global Brands list
I took 20 stocks from the top 30 from 2004 once again as a hypothetical portfolio. And once again I removed a handful of companies not listed in the U.S. (like Samsung), brands owned by parent companies (including Gillette and Nescafé), and others that didn't have ten full years of data due to being spun-off, acquired, or going private (such as Philip Morris being spun-off from Altria in Marlboro's case, Budweiser, Dell, and Merrill Lynch). Some of these events would have been positive for shareholders, others negative. Ultimately we're left with the list on the left. Like I said, similar to the most recent list, save for a few of the big tech names. So if we take our time machine back to 2004, but equal-weightings of these 20 stocks and hold for 10 years, what would the results have been?

The results are probably what most people might have expected in the first place. This group of "what you know" stocks did a bit better than our large cap index ETF, but equal-weighting can lead to returns that look a lot more like mid caps once you decrease the mega cap influence. This basket of 20 stocks ended up in about the same place as our Russell 2000 ETF, and worse off than IJH (which tracks the S&P 400 Mid Cap Index).

My little experiment is just one of endless ways to pick stocks that fit with a "invest in what you know" strategy. And in this case, the buy what you know strategy tracked pretty closely to passive indexing. I don't know many small cap brands off the top of my head, but they did just as well! Most people might pick to invest in some of the smaller, but still extremely well-known brands closer to the bottom of the Interbrand list. Or in an attempt to find the next big thing, many may instead invest in smaller companies that potentially might have more upside potential - maybe familiar companies about to IPO. In any case, this was merely my attempt to pick out a number of companies that most people are probably familiar with.

Of course, I don't recommend you buy or sell stock based on what I've written here (always do your own due diligence with information from multiple credible sources or consult a financial advisor!).

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