‘Bad’ Stocks Outperform for Good Reasons

(Bloomberg Opinion) -- The stock market has a nasty habit of turning sure things into sure losers. Consider Nike Inc. In a recent commentary, my Bloomberg Opinion colleague Barry Ritholtz explained how many failed to understand the opportunity presented by the sneaker and sports-apparel maker’s signing of controversial former National Football League quarterback Colin Kaepernick to a marketing deal. Many expected Nike’s shares to suffer amid political backlash, but they didn’t.

I’d like to expand on Ritholtz’s excellent insights by first taking a look at the practice of socially responsible investing, which everyone knows hasn’t worked out well. A socially responsible investor generally avoids certain companies that are perceived to engage in antisocial behavior, such as tobacco or firearm companies. The theory is that companies that seek to do good and have good governance practices will be rewarded by the stock market. But, broadly speaking, that hasn’t been true. Tobacco stocks have outperformed the S&P 500 Index for years on a total return basis. Some have figured this out and invest exclusively in these “vice” stocks.

So, why do “bad” stocks outperform? It actually has nothing to do with companies being “good” or “bad,” according to a 2017 research note by hedge fund firm AQR Capital Management LLC. The firm posed the case of two portfolio managers, one that is unconstrained and can invest in anything, and the other that has certain constraints.

Simply put, one cannot expect a portfolio manager who has constraints to outperform one without constraints. The manager that is constrained could certainly outperform the one that isn’t, but it would be exceedingly difficult. After all, the constrained stocks must be held by someone, and, logically, those investors must hold more of those stocks than they otherwise would. In order to induce them to buy these stocks, they must be compensated with higher returns.

But here’s where things get interesting: Constraints don’t just have to do with socially responsible investing. There are all kinds of constraints. There are explicit constraints, such as a large-cap manager not being able to invest in small-cap stocks. Or a growth manager being unable to invest in value stocks. But there are also implicit constraints. That’s when a stock can’t be owned because it would be embarrassing or we find it detestable for some reason. Perhaps a stock that has performed so poorly that it has become a running joke and an embarrassment to any portfolio manager. But remember, someone must own these stocks, and they must be rewarded with higher returns.

When Nike signed its marketing agreement with Kaepernick, the stock suddenly became subject to constraints: Republicans might refuse to own it. We don’t really know if Republican-leaning portfolio managers sold the stock. If they are professionals, they probably don’t let their politics get in the way of their investing. But, sure, there probably was a fairly large group of investors who divested themselves of the stock for political reasons. Thus, Nike had constraints and some people — liberals — had to own it, and they were rewarded with higher returns.

I like to think of the stock market as one big linear algebra problem. Every stock has constraints of some kind, and the ones that have the most tend to win. The stock with one of the best long-term performances, Monster Beverages, has all kinds of constraints, the main one being that it sells products that are profoundly bad for your health. It has returned 63,124 percent over the past 20 years, versus 116 percent for the S&P 500 Index.

Then there’s the persistent outperformance of index funds, which are the ultimate unconstrained investors. They must own all stocks, even the bad ones. In the last few years, you’ve seen hedge fund managers absolutely flummoxed by the “bad” stocks they try to short, which always seem to end up outperforming.

Investors who have been around for a few cycles like to complain that the stock market “doesn’t make sense anymore.” There are a lot of price-insensitive buyers of the “bad” stocks that active managers try to avoid. Managers have become so awful at outperforming index funds, I’ve often wondered what would happen if they actually did the opposite and tried to underperform their benchmark by picking bad stocks. My guess is that they would inadvertently end up outperforming! 

It is often tempting to impose our political views on our investing. There are a lot of brain cells killed on Twitter about which political party is best for the stock market. The quants will say there is probably a logical, rational, mathematical explanation for everything. I certainly hope so.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of "Street Freak" and "All the Evil of This World." He may have a stake in the areas he writes about.

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