Efficient market theory has been a leading academic model of market behaviour in the last decades. However, many studies and investors have managed to challenge this theory, supported on research and practical evidence often called “financial anomalies”, among which reputation finds abundant validation. To contribute further with this discussion, this research develops on the risk-return analysis of five specific reputation components: Innovation - Social Responsibility - Management Quality - Long Term Investment - Financial Soundness.
The study will feed on the data from the Fortune Magazine “most admired” survey as a proxy for reputation components for the periods April 2008 to April 2012. The main objective is to establish the impact these five reputation components mentioned above have on return and risk performance, and discuss the on the findings.
The research employs descriptive and inferential statistics to compare and measure between five reputation portfolios (Innovation, Quality Management, Corporate Social Responsibility, Financial Soundness and Long-Term Investment potential) and the S&P500, which is taken as the market benchmark. The main findings are four reputation portfolios that statistically outperform the S&P500 index and one that does not. The financial soundness portfolio is the only one that underperforms the S&P index, and the Long-Term Investment Potential portfolio is the portfolio with the highest risk-adjusted return among all.
The research provides conclusions regarding the validity and limitations of efficient market theory, particularly the best and worst performing portfolios. A possible explanation concerning particular results for best performing reputation portfolio is provided, as well as recommendations and limitations of the study.
1. Research objective
This research departs from the work developed on reputation, particularly concerning the Fortune’s magazine survey. In this sense, it assumes that high reputation portfolios are actually statistically significant with regard to positive abnormal returns compared with market benchmark indexes, and that the market does not fully reflect this information into prices. This study relies on the information of the most admired companies by the Fortune Magazine. The survey constructs the reputation score from seven attributes, five of which are used in this study, the ones considered most relevant for research and academic purposes:
- Innovation;
- Social Responsibility;
- Management Quality;
- Long Term Investment;
- Financial Soundness.
2. Research scope
From an academic perspective, this work would bring additional evidence on the subject of market anomalies or inefficiencies under the efficient market theory. It would also provide support for alternative approaches on the field of equity valuations, as they are increasingly more concerned with intangible asset valuations of firms (Danthine and Jin 2006).
From the industry point of view, this work could help encourage the belief in a logic, fundamental, more qualitative and less quantitative principles that can lead to better investment returns, by showing that not only a good financial analysis in its classic sense is needed to have an accurate valuation, but also a broader analysis that takes into account the firm as a hole (financial, human, intangible assets). Finally it could also suggest that the work of the few investors that have managed to outperform the market can be somehow modelled and theorized to help institutional and retail investors take better decisions.
3. Literature review
Literature can be found at the end of the report, since it is quite extensive, only the theory used will be mentioned, not the extensive authors and work.
- Efficient market theory, inefficiencies and anomalies.
- Inefficiencies and competitive advantage.
- Practical cases of market inefficiency, research papers.
- Intangible assets and reputation: Source of competitive advantage.
- Reputation.
IV. Research methodology
The research objective is to identify which attribute of reputation is the most and least accurate to predict superior stock performance out of five academically relevant attributes:
- Innovation;
- Social Responsibility;
- Management Quality;
- Long Term investment;
- Financial soundness.
The survey is disclosed each year on March’s edition of Forbes magazine. The survey tracks the 1000 largest US companies and the 500 largest world companies by revenue. Then they select the 15 largest for each international industry surveying a total of 687 companies from 30 countries. The survey asked executives, directors and analysts to rate companies in nine criteria, five of which these research has selected. A company must rank in the top half of its industry score to be listed (Forbes 2013).
The research will build five equally weighted portfolios for each reputation attribute and will track its monthly return performance from April 2008 to April 2012. Performance will be measured against a market benchmark, the returns of the S&P 500 index from the Dartmouth Tuck MBA database (2013). If a company is replaced in a group in the next year, the portfolio is rebalanced to include the new firm, and excludes the exiting firm. Information on return, standard deviation, risk premiums, beta, Jensen’s alpha and Sharpe ratio will be calculated for each portfolio.
5. Results
5.1. Descriptive results
Information is displayed to account for both descriptive and inferential statistics about each portfolio. Below, the descriptive information covers measures of monthly returns, standard deviation and risk measures against the benchmark portfolio, the S&P 500 index. (See Fig. 1 to 5)
All portfolios, except the Financial Soundness portfolio, present higher gross return than those of the S&P500. When analysed for risk adjusted measures and idiosyncratic return of portfolios, there is one portfolio that outstands having both a higher Jensen’s Alpha and Sharpe Ratio: the “Long Term Investment” Portfolio.
5.2. Statistical tests, inferential results
Having performed descriptive and statistical analysis, one portfolio is deemed worthy of having a closer look to test the statistical hypothesis concerning its mean and standard deviation, the Long Term Investment portfolio. This will help answer the research questions:
1. Are the values of returns of each portfolio greater to that of the market’s benchmark (in this case, the S&P 500 equities index) ? (See Table 1)
As shown above, we use a 90% and 95% significance level, which leads to rejection of the null hypothesis for all portfolios but the PFS (Portfolio of financial soundness) at the 95%. P-Values were also calculated to account for the smallest level of significance at which the null hypothesis can be rejected.
2. Is the mean difference of returns between the highest performing portfolio and lowest performing portfolio, statistically significant? (See Table 2)
Because there is strong evidence to believe that the samples are highly correlated, the T-test in this section was performed on data of paired observations, which are believed to be dependent. Returns of both portfolios would seemingly be influenced by similar risk factors (i.e., market returns). The test leads to the rejection of the null hypothesis on a 90% significance level.
3. Is the standard deviation of returns of the high performing portfolio, equal or higher than that of the market’s benchmark?
Because the research wants to account for risk adjusted returns, and ensure that results are not given due to higher volatility, a statistic to test the equality of variances between the PLTI (Portfolio of long term investment) and S&P500 (Benchmark portfolio) is calculated. The null hypothesis states that these two measures are not different. This means that there is no statistical evidence to affirm that the variance of the PLTI is higher than that of the benchmark portfolio.
4. To account for risk adjusted returns, what is the rank of the sharp ratio of the portfolios?
As presented earlier in the chapter, the PLTI portfolio had the highest Sharpe ratio among all five reputation and benchmark portfolios. (See Fig. 6 and 7)
5. What is the return of Ph, the portfolio with the highest performance (PLTI) that is attributable to idiosyncratic risk?
As presented earlier in the chapter, the PLTI portfolio had the highest Jensen’s Alpha among all five portfolios. (See Fig. 8)
After having performed the descriptive and inferential statistic analysis, two portfolios seem to outstand from the five reputation component portfolios: The long term investment portfolio, which presented statistically significant higher risk adjusted returns among both the S&P500 index and the portfolio of financial soundness companies which presented below risk adjusted returns against the S&P500 index.
6. Discussion
This section develops from the previous chapter to deliver analytic and critical discussions derived from descriptive and statistical inference results on the two portfolios components of reputation, the one that outperformed (PLTI) and the one that underperformed (PFS). Hence, a discussion concerning market efficiency and George Soros’ reflexivity theory will be displayed to help explain both results.
Efficient market theory states that prices always reflect all available information about an asset, and therefore that market prices are always right, which would not allow an investor with the same available information about an asset to have a higher return than the market. On the other hand, the theory of reflexivity affirms that the market is actually never in equilibrium, so the price almost never reflects the right (intrinsic) price. Reflexivity theory says that market’s perceptions are always changing, which in turn change prices, which afterwards change fundamentals, which once again will change market's perceptions in a reflexive or revolving relationship.
6.1. Financial Soundness portfolio
There are many definitions and interpretations for financial soundness among academics as well as analysts and managers (Atkesson, Eisfeldt and Weill, P. 2013). To have a consensus of its meaning then, it will be only a matter of procedure, and the research will assume that it means to have a healthy above standards measures when performing a financial analysis based on the components suggested by the CFA (2013): activity, profitability, liquidity and solvency.
The results deriving from the risk-return analysis on the Financial Soundness portfolio against the other components of reputation and the S&P, are conclusive and help the research with providing evidence on its thesis about market efficiency. Therefore, this is the portfolio that actually helps prove the thesis behind this research, which is actually the least performing portfolio, and most importantly, a portfolio that performs worst than the S&P500 index. How can it be explained that a portfolio composed of the most financially sound firms would perform worse than that of the rest of the portfolios and also worst (or in the best case equal) than the S&P? How can the theory of efficient markets help explain this result? Does this mean that crafting a traditional financial analysis of firms (CFA 2013) that involves activity, profitability, liquidity and solvency issues will lead to having the same or sometimes worst returns than those of the market? Can there be something additional said about the efficient market theory?
To begin, it is useful to recall what the theory of efficient market has to say about information and prices: this theory states that markets process information efficiently into prices. Thus, the hypothesis of security prices fully reflecting all available information at any point in time (Fama 1970:388) suggests that an investor cannot obtain consistent outperforming results on average over the market, on a risk-adjusted basis. If the research were to focus then solely on financial soundness information, the theory would actually prove to be true. If a portfolio were to be built out of firms that experts, managers and analysts deem to have higher financial soundness, based on this information, this portfolio would not lead above risk-adjusted returns.
6.1.1. Financial Soundness portfolio results
Mean return for PFS is higher in only 1 of 5 years. Yearly Standard Deviation is higher in 2 out of 5 years. Sharpe ratio is only higher in 2 out of 5 years. Portfolio’s beta is 0,17 showing relative low correlation with market. The portfolio seems to underperform in both uptrend and downtrend market prices. (See Fig. 9 and 10)
Results of the Financial Soundness portfolio seem to confirm the efficient market theory. However, it can be discussed further that “only” information regarding financial soundness seems to be efficiently incorporated into price. As the research has proved in the previous results, there are other components of reputation, therefore other types of information that the market does not seem to include efficiently into price: (See Fig. 11).
6.1.2. Financial Soundness portfolio discussion
Results of the Financial Soundness portfolio seem to confirm the efficient market theory. However, an alternative discussion is that “only” information regarding financial soundness seems to be efficiently incorporated into price. As the research has proved in previous chapters, there are other components of reputation; there are other types of information that the market does not seem to include efficiently into price. One way of describing this, is that the market has many sources of information, only one of which it is processing efficiently, the rest of which the market disregards erroneously. (See Fig. 12)
Two conclusions can be drawn from this:
- If we accept that efficient market theory does work, it is only a matter of time until the markets begin to understand that there are other types of information that it should process efficiently, and when that time comes, strategies like the one exposed in this study will be only as profitable as the market.
- Today, information that seems to be processed efficiently by the market would be reserved only for that of financial soundness, which seems logic when looking at the past trends and the work from industry analysts. Tomorrow this information will expand to other types of information, because otherwise this would create arbitrage opportunities, and the market always fills those gaps. However, tomorrow when this information will become efficiently processed, there will be other additional information that the market did not know was important or did not process in an efficient manner. Because information is dynamic, the market is always changing, and firms are composed of human beings, this is a social environment of ever-changing information where there will always be new sources that will lead to market inefficiencies which academic community and exceptional investors will always try to exploit.
6.2 Long-term Investment portfolio
There is a reason for leaving the portfolio of long-term investment last in the discussion, which seems to be clearer after having discussed the financial soundness portfolio. An apparent contradiction, as long term investment and financial soundness seem so close, correlated, and joint when analysing a firm. How can the research explain the former being the best performing portfolio, and the latter the least performing one? Should not it be upfront that if a firm is supposed to have financial soundness, it should lead to a high long-term investment result?
The concept of a higher long-term investment is direct : because this study as well as Fortune survey, assume that an investment is judged from an investor’s (shareholder) point of view, a firm only needs to show higher total shareholder return compared to its peers, past or benchmark. This means that if the dividends plus capitalization of the value of the stock relative to the previous period is higher than the subject of comparison, on a consistent basis, this firm will show a higher long-term investment (Investopedia 2012).
The way of measuring this concept over the past can therefore said to be objective. However, its estimation for the future results is very subjective as it depends on valuations of many variables, and even further, on estimates about what the market will think and how it will calculate such variables. Estimating the long-term investment of a firm involves then, the ability of forecasting variables for the future cash-flows of a firm, which in turn depends on forecasting the economic environment that the firm will be experiencing for that long term, and in addition, it will depend on whether the forecast is congruent with that of the market. Variables concerning cash flow concern projected sales, costs, capital expenses, accounting, depreciation and inventory methods, and financing structures, among others (CFA 2013). All of them, variables that have a considerable impact on the future cash flow of a firm, and that, when estimated, become subjective even though they try to be as accurate and objective as possible. Variables concerning the economic environment of the firm for the period to be measured involve interest rates, inflation, GDP of the markets in which the firm is operating, as well as an analysis about the industry in order to estimate the potential growth, based for example on Porter’s five forces industry analysis (Investopedia 2013). Finally, the factor that requires more accuracy and the one that relies on more subjectivity: What will be the opinion from the market concerning the state of the economy and that of the particular firm being studied, which is simply measured by the price the market will give to equities indexes for example, or to the firm being analysed.
6.2.1 Reflexivity theory
The study intends now to step away from the efficient market theory, and rely on George Soros theory of reflexivity to introduce and help explain the discussion of results for the long-term investment portfolio. According to Soros (1987) the theory of reflexivity states that market prices are consequence and cause of fundamental information. This is possible because between financial assets prices, and fundamental objective information, there is an interpreter and creator of both situations, the market, which judges and distorts each event with its subjective opinion: what it thinks about both prices and fundamentals. (See Fig. 13)
In his book, The Alchemy of Finance (1987) Soros gives a clear example of how the theory of reflexivity works on the equity markets. It will be used to give a brief explanation about reflexivity and equity markets with the figure below, which would help explain the results and enrich the discussion for the Long-Term Investment portfolio.
Figure 15 shows the red line is the market line (price), and the blue line is the fundamental line (P/E or whatever fundamental is to be measured). What the theory says is that both lines interact together, the market behaving in a subjective way going from excessive optimism to excessive pessimism, evaluating the fundamentals, affecting and feeding from the fundamental line at each period of time: (See Fig. 14).
The interpretation given by the research on this theory, in connection with the discussion results for the long-term investment portfolio lies in the subjective component of market judgement. A component that helps both to increase market prices when fundamentals are sound, and reduce them drastically when fundamentals become weakened. This all happens with market prices interacting in ways sometimes (most of the times) exaggerated relative to fundamentals. This is the reason it is called reflexivity, because prices and fundamentals “react” on each other, as in a reflexive relation.
6.2.2 Long-Term Investment portfolio Results
Specific results on descriptive and inferential statistic for this portfolio are found on the data analysis chapter. The most important results, contributing to a robust discussion are the following:
Mean return for PLTI is higher in 3 out of 5 years. Yearly Standard Deviation is higher in only 1 out of 5 years. Sharpe ratio is higher in 4 out of 5 years. Portfolio's beta is 0,22 showing relative low correlation with market. The portfolio seems to outperform both in uptrend and downtrend market prices. (See Fig. 15)
6.2.3 Long-Term Investment portfolio discussion
This was the portfolio with both descriptive and inferential statistical tests that provided with higher risk adjusted returns among the five reputation component portfolios analysed. This study, based on the objective of discussing efficient market theory, its anomalies, and alternative explanations of market performance intends to base the case of market subjectivity as the main reason.
If theory of reflexivity is accepted, the reason of the Long-Term investment portfolio to outperform the S&P is upfront : the market, represented in this case by executives, managers and analysts of the industries composing the market, gave a subjective measure of the firms it considered were the ones poised to have better investment results than the market itself. Picture there were three components now, the fundamentals, the market, and the best performers among the market according to the market. (See Fig. 16)
Because of the subjective characteristic of the market, which is tangible when concerning forecasts about the future, and because it is the market itself who sets future prices, the Long-Term Investment portfolio might become a self-fulfilling prophecy.
7. Conclusions
Findings suggest that the most appropriate attribute of reputation to predict superior stock performance is the Long-Term Investment portfolio. This portfolio scored a mean yearly return of 13,56%, which was the third highest; mean yearly Standard Deviation of 15,78%, the lowest among the five reputation portfolios and the S&P500 index; 9.57% Jensen's Alpha and 0,86 Sharpe ratio which were both the highest ratings recorded against all of the five reputation portfolios.
This leads to the conclusion that, accepting certain firm reputation attributes as information that has not been efficiently processed by the market into stock prices, the component that accounts the most into reputation, is the fact that the firm has the perception within the market and industry individuals, of a higher ability of producing long term investment results.
Let the research finish with two remainders from one of the most influential investors and authors of the last decades:
“We are dealing with social sciences and not with natural sciences. Thus, the method used, in the lack of a better one, is just suggesting that with no better options, it would be better to use this information, but no guarantee is provided of its effect at all times. Scientific method is based on the presumption that a successful experiment corroborates the validity of the hypothesis that it was designed to test. But in situations with thinking participants, experimental success does not assure the truth or validity of the statements that are being tested” (Soros 1987).
“Indeed, the believe in efficient markets renders markets more unstable by short-circuiting the corrective process that would occur if participants recognized the markets are always biased. The more the theory of efficient markets is believed, the less efficient the market becomes” (Soros 1987).
8. Recommendations
In light of the previous discussions and conclusions the study recommends further research to construct portfolios of worst reputation components and to extend the periods of research. Also it would be of use to find another source or proxy for reputation components.
Besides methodology recommendations, there would be an interesting discussion regarding the means of objectively measuring reputation attributes and incorporating them into valuation methods. For example, how to measure the value of innovation, quality of management or SRE initiatives?
