Sat, 18 Apr 2015
New research shows that holding unpopular stocks and avoiding hot ones can lead to outperformance over time, says Zebra Capital Management's Roger Ibbotson.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Should investors focus on unpopular stocks? At the Morningstar Institutional Conference, I interviewed Roger Ibbotson, chairman of Zebra Capital Management and a professor at the Yale School of Management, to discuss those topics.
Roger, you have been looking at the idea of liquidity. Lately, you've refined liquidity to look specifically at popularity, and what a lot of your research points to is that unpopular companies tend to outperform over time. Let's discuss how you define popularity.
Roger Ibbotson: Well, we started out looking at liquidity, and what's so unpopular is illiquidity--less liquidity. People so much love liquidity that a little less liquidity becomes unpopular. But we came to see, especially when we started measuring it, that we were actually picking up more popularity than liquidity in some of our measures. And so I really started shifting my thinking. Maybe it's a little odd because I published a paper called "Liquidity as an Investment Style," which won awards and so forth. But in the end, I see this as a much broader concept, and liquidity is just a small part of that.
Benz: So, how do you measure popularity?
Ibbotson: Well, the way we originally measured it--and the way we still do--was turnover. That's the part that is in the published papers and so forth. It's the number of shares that trade divided by the number of shares outstanding over some historical period. The stocks that trade less tend to be the less popular, and the stocks the trade more tend to be the popular ones. And that measure has a big impact on returns, actually: Less-popular stocks have much higher returns than more-popular stocks.
Benz: One question that might arise is that, for a long time, people have known that value stocks tend to outperform and small-cap stocks tend to outperform. Do you think that popularity is picking up on some of the small-cap value effect that has been well documented? Or do you think it's something distinct?
Ibbotson: It's all-encompassing. It includes that. Small stocks are really unpopular. Individuals don't think of them as unpopular; but when you go to an institution, [if the institution] finds a great small stock to buy, they can't buy it, really, because they move the price too much or because they just don't have the capacity. Even buying a big chunk of the stock doesn't make it a big part of the portfolio. So, they do all the work, and they don't get anything for it.
Institutions really would prefer to underinvest in small-cap stocks. They're the major players in the market. They don't like them; therefore, they are unpopular. Things that you don't like get lower prices, but that means higher future returns.
With value, it's even more extreme. In value, investors do not like those value stocks because when you actually look at the names, there is something wrong with those companies. They may have bad management or a bad history of earnings or some bad tail risk, actually, where they've done poorly over some past period and people just don't like them. But that's where the bargains are--buying those things they don't like. But people like those hot stocks, those growth stocks. Those stocks have great stories. They have wonderful stories. They have mesmeric stories when you hear about what those companies are up to, but their prices are high. And they're high based on stories, not so much on reality.
Benz: So, it sounds like this unpopularity, in your view, explains a lot of the various predictors of better performance that have been out there for a while. It sort of hangs over the small-cap effect and the value effect and so forth.
Ibbotson: Yes, it does. It explains those premiums in the market. But it not only explains premiums, it actually explains things that we wouldn't call premiums--all the mispricings that we've had in the market. It also explains that, too.
Benz: So, Zebra Capital Management has a product that is designed to focus on these unpopular companies. For individual investors who aren't inclined to buy the hedge fund but kind of want to incorporate this concept into their own investing, what should they be thinking about? What sorts of practices should they be incorporating into their portfolio management? And what sorts of investment types should they be focusing on?
Ibbotson: Well, let me say that for investors, first of all, the things that clearly do the worst and have the biggest impact of all are the stocks that are really popular, the really hot stocks. Those are the ones that we have in long-short portfolios, as well as long-only portfolios. Those are the ones we short, those hot stocks. Even in a long portfolio, just avoiding those hot stocks is a big part of getting excess returns in the market. Most people, of course, crowd into them. And basically, you have to go against your own human nature. You hear all these stories out there--it's so exciting. They're on the news, and they're talked about. Those are the stocks that tend to have the worst long-run returns.
Benz: How about how to capitalize on the unpopularity effect? I should avoid the hot stocks, but what do I buy instead?
Ibbotson: Actually, the biggest thing you could do is [just avoid those hot stocks]. That's step one.
Benz: Avoid the really frothy companies.
Ibbotson: Step one is to avoid those stocks. Step two is a harder step because you have to look for the really overlooked things in the market, which requires much more work and maybe isn't so easy for the individual audience to come up with that sort of thing. But because we, [at Zebra Capital Management,] do more grand searches through all kinds of data and so forth to find these sorts of things, [it's easier for us]. So, it probably isn't as easy to implement, but indirectly you could implement it by buying value stocks or buying small caps or overloading on those sorts of things. Those are things that individuals can do. They fit into the Morningstar size-value matrix. So, certainly, you could overload a bit on those categories that I said were unpopular; that's something individuals could easily do.