CrossingWallStreet points to a story by Daniel Gross in Slate that turns conventional wisdom on its head. Gross is great writer who is able to consistently produce well-written articles that (often) have a unique take on financial and economic news. In response to a recent poll on consumers’ opinions of various corporations, Gross takes a look at the notion that buying “good” companies yield positive returns. According to this research high reputation companies tend to act like growth stocks.

Intuitively, it makes sense that highly respected companies are overvalued in hot markets. Value investors school themselves to look for stocks that are hated by the market and to avoid stocks that are loved too much by the market. When everybody owns a stock and all the analysts rate it a buy, a stock’s value tends to rise—and there’s frequently nowhere for it to go but down. Conversely, when analysts rate a stock as sell and many fewer people own it, the stock may be on the verge of failure—or it may be on the brink of a turnaround. And therein lies the opportunity.

It is intuitively appealing to think that buying good companies, however defined, should yield positive results. We think that this notion is inextricably linked with the principle popularized by Peter Lynch, to “buy what you know.” We all know Johnson & Johnson (JNJ), Coca-Cola (KO), and United Parcel Service (JNJ), and by golly we like them! The problem with this notion is that it plays right into investors’ tendency towards overconfidence. We honestly think, “we know Coke’s business” therefore we have some insight into the stock price.

However any one with a glancing knowledge of psychology should see the fallacy of this argument. If a company is already known to be a good, solid, profitable company, then in all likelihood the rest of the investing world knows this as well. This notion has been studied previously first by Michelle Clayman in “In Search of Excellence: The Investor’s Standpoint” (no link) in the Financial Analyst Journal, and by Michael E. Stolt and Meir Statman in “Good companies, bad stocks,” in the Journal of Portfolio Management.

As we noted in an earlier piece on Munger and Lampert, it is only by generating novel viewpoints (and acting upon them) can investors really distinguish themselves from the investment masses. Buying stocks because they seem like “good companies” is a mistake often made by novice investors. Doing your research you help can graduate from this simple notion.

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