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Record executive Scooter Braun employed a simple formula to achieve wild success with Justin Bieber and other artists: identify talented performers right before they become household names. Yale Professor Roger Ibbotson thinks that investors should maximize their returns with a similar strategy — a strategy that hinges on popularity.
At the 72nd CFA Institute Annual Conference, hosted by CFA Society of the UK, Ibbotson compared a box of Bayer aspirin with a generic version of the drug. Their retail prices vary, even though the content is the same, and yet Bayer manages to attract a significant consumer base for their more expensive product. Stocks are no different, according to Ibbotson. “Popular stuff has higher valuations but lower expected returns,” he said.
Like many ideas in behavioral finance, Ibbotson’s thesis seems very common-sense. Its originality lies in the fact that unlike the CAPM, which correlates returns with risk, it considers the popularity of an asset. The model builds on CAPM to create PAPM, a Popularity Asset Pricing Model.
Some delegates in the audience were intrigued by the PAPM model. “I always felt CAPM was missing something, that the assumptions it made were a little bit too simplistic, and therefore as a practical tool, I didn’t find it very useful,” said Timothy Nuding, CFA. Nuding is Managing Partner of Prosperity Capital Services and board member of CFA UK. “PAPM does extend [CAPM],” he said. “It was intuitively very satisfying to have more factors that explain the reality we experience.”
However, Ibbotson’s presentation at the conference did not describe the concept of popularity in depth, possibly due to time constraints. “I am not convinced we have a defensible way of measuring these extra factors,” Nuding said.
Ibbotson is co-author of a CFA Institute Research Foundation book, Popularity, A Bridge between Classical and Behavioral Finance, that discusses these ideas in greater detail. To define popularity, it uses three characteristics: brand value, competitive advantage, and company reputation. The values are quantified by using Interbrand’s annual “Best Global Brands” report, Morningstar’s economic moat ratings, and Nielsen’s Harris Poll reputation quotient.
On the stock level, Ibbotson and his co-authors looked at tail risks — investors tend to dislike stocks with returns with high tail risks, as measured by negative coskewness with the market. In other words, securities tend to be less popular if they are expected to experience large losses when the market falls; this gives them higher expected returns.
The book also investigates lottery-like stocks, i.e., ones that have a small probability of a large payoff. Research shows that they are strongly preferred by investors, and lottery stocks have lower returns in the future, consistent with the popularity theory. Using these metrics, the book concludes that investors are willing to give up gains to hold stocks that they like.
During his presentation, Ibbotson compared growth and value stocks to illustrate the power of popularity. In theories put forward by behavioral finance, investors gravitate towards growth stocks that have stories attached to their success, because human beings respond positively to stories. We are less inclined to prefer value stocks, which inherently tend to have something wrong with them. The flows of such stocks act as a deterrent, which is why they are discounted.
Once value stocks are shown to produce returns, investors flock, and the stocks become popular. Ibbotson explained that that’s why returns slumped after the 2008 financial crisis. Once it becomes evident that returns are no longer outsized, popularity suffers, and the returns of value stocks increase once again. Now that value investing is seeing a renaissance, Ibbotson explained that investors are coming back.
Nuding agreed with Ibbotson’s summary of a popularity cycle, identifying a way for PAPM ideas to be applied to investing. “Popularity does move in cycles,” Nuding said. “The real value to the theory is coming up with ways of predicting these cycles.”
PAPM takes us back to a concept familiar to most readers of this blog: investing is hard. Assets are usually unpopular for a reason, and finding the ones that will turn around requires both skill and luck.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Neil Walker