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Are great companies really better investments?

(MoneyWatch) "In Search of Excellence," the 1982 bestseller, the authors Thomas Peters and Robert Waterman identified six financial indicators of excellent companies:

- Five-year growth of total assets
- Five-year growth of shareholder equity
- Five-year return on sales
- Five-year average return on average total capital
- Five-year average return on average total equity
- Five-year average year-end price-to-book.

Using the trailing five fiscal years of data, Barry B. Bannister and Jesse B. Cantor, authors of the study "Revisiting In Search of Excellence: A Portfolio Management Perspective," compiled a list of stocks in the top one-third and bottom one-third in all six criteria. They then constructed two equal-weighted portfolios -- one consisting of the excellent companies and the other of the un-excellent ones. On average, each of the two portfolios contained 31 stocks. The results may surprise you.

They found that $1,000 invested in the un-excellent companies at the end of each June beginning in 1970 (total investment of $41,000) would have appreciated to $1,615,054 by June 30, 2013. This compares to an ending value of $502,124 for the excellent companies portfolio. In relative terms, the un-excellent portfolio outperformed the excellent one by 222 percent. The same series of investments in the S&P 500 Index would have produced a portfolio of $637,048. And people who had invested in gold would have had an ending value of just $167,504.

The authors also noted that "investors in excellent quality stocks have defensive characteristics." Yet they found that excellent companies outperformed in only 11 of the 22 periods that featured global economic difficulty (defined as years in which global real GDP growth was than the average of 3.65 percent). On the other hand, they found that in the other 17 periods, the un-excellent companies outperformed 15 times (88 percent).

The takeaway for investors is that what might be a good measure of the performance of the management team isn't necessarily a good measure of what makes a high-returning investment. The price you pay for "excellence" clearly matters -- "excellent" companies tend to trade at high price-to-earnings and high price-to-book ratios, which leads to the results shown above. The findings provide further support to the benefits of a disciplined value approach to investing. 

Image courtesy of Flickr user 401(k) 2013

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