Meinung

Apple and the Halo Effect

There is no patent remedy for constant success in financial markets, even if countless guidebooks in business literature claim the opposite. For investors, it’s therefore best to stick to the great wisdom of Forrest Gump's mother and be prepared for surprises.

Alexander M. Ineichen
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Forrest Gump, who’s momma often argued that life is like a box of chocolates, invested his proceeds from the Bubba-Gump Shrimp business in «some kind of fruit company». He did well. The market capitalisation of the «fruit company,» Apple, rose from $5 billion in 1994, when the Forrest Gump movie was released, to over $2 trillion just recently.

Investment life would be much easier if good companies were good investments and that was the end of it. Remember In Search of Excellence in the 1980s? The book was widely read by anyone remotely interested in business. It was one of the biggest selling business books ever, selling three million copies in its first four years.

The book «defined» corporate excellence. The subtitle was Lessons from America's Best-Run Corporations. Tom Peters and Robert Waterman, the two authors, identified companies that were a blueprint for corporate excellence. Some of the companies that fit the bill and still have name recognition today are Boeing, Disney, IBM, Intel, Johnson & Johnson, McDonalds, and Merck, just to name a few.

In 1987, Michelle Clayman, founder of an institutional money management firm in New York, published a paper1 in which she tracked the performance of the stocks of these companies in a period following the ranking, 1981-1985.

These firms had established strong records of performance prior to 1980. By 1980 they had become growth stocks. If the market overreacted and overpriced them, their performance after 1980 should have been poor as the market corrected, and the prices of the stocks fell to more reasonable levels.

Clayman compared the performance of the «excellent» companies with another group she called «unexcellent». These were the 39 companies in the S&P 500 Index population that had the worst combination of the characteristics as of the end of 1980.

Excellence is mean reverting

Clayman revealed that the stunning characteristics of the excellent companies quickly reverted towards the mean in the years that followed their 1980 screening. The excellent group rose from 100 to 181.6 over the five-year period while the unexcellent group rose to 297.5.

The unexcellent companies had also reverted towards the mean. The market did not anticipate the mean reversion, an iron rule in financial markets:

«Reversion to the mean is the iron rule of the financial markets.»2
—John C. Bogle (1929-2019), Founder of the Vanguard Group

Phil Rosenzweig, a professor of strategy and international business at IMD in Lausanne and a bestselling author, in The Halo Effect made a similar comparison as did Michelle Clayman. He examined the companies from a book titled Built to Last by Jim Collins and Jerry Porras.

Like In Search of Excellence in the 1980s, Built to Last became a business book classic in the 1990s. Collins and Porras were in search not of excellence but developed «timeless principles» that separates the wheat from the chaff. These principles allowed them to name eighteen Visionary companies and set them apart from eighteen Comparison companies. Some of the names were General Electric, Boeing, Citicorp, Ford, etc.

You can guess what happened; «timeless» was rather short lived. GE for example, was a $83 billion company when Built to Last was published, was a $0.57 trillion company by September 2000, and a $55bn company twenty years later. The fate of the Visionary companies in the period after the book was also pretty much the same as with the «excellent» from the 1980s: mean reversion. This is how two experts on creative destruction put it.

«Managing for survival, even among the best and most revered corporations, does not guarantee strong long-term performance for shareholders. In fact, just the opposite is true. In the long run, markets always win.» 3
—Richard Foster and Sarah Kaplan, formerly with McKinsey & Company

Delusion of lasting success

Failure destroys wealth. This means a long-term investor needs to, ideally, avoid failure, or, somewhat less ideally, survive it unharmed or little harmed, for operations and investment life to continue. There are few families and institutions that accumulated wealth and kept it for centuries.

The reason why an accumulated pot of wealth does not last for centuries is because it is difficult to protect it from failure, such as wars, hyperinflation, expropriation, sticky authoritarian fingers, third-generation profligacy, fourth-generation idiocy, etc.

Staying in business is also difficult despite thousands of how-to business books suggesting otherwise. Those who claim it is easy are either talkers rather than doers or managed to delude themselves. Phil Rosenzweig calls this delusion the Delusion of Lasting Success:

«Almost all high-performing companies regress over time. The promise of a blueprint for lasting success is attractive but not realistic… Lasting business success, it turns out, is largely a delusion.»4
—Phil Rosenzweig (b. 1955), American business school professor and author

Sometimes only a whiff of wind is required to bring down a house of cards, i.e., small and seemingly trivial disturbances can trigger a series of events that have large consequences.

Colloquially this is referred to as the butterfly effect. Examples are a Tunisian vegetable vendor’s self-immolation triggering the Arab Spring, or a rise in Chilean subway fares resulting in rioting and Chile potentially entering a Venezuela-like negative economic feedback loop.

The whiff of wind is not cause of unfolding events of great consequence, just the trigger that pushes a system that is instable over the edge.

From history we know that companies with large market capitalisations can turn into companies with much smaller market capitalisations. Sometimes this is even true for a whole group of companies, like for example the Nifty Fifty in the 1960s and 70s.

Whether the Nifty Fifty stocks are to the 1970s what FANGMAN stocks are to the 2020s we cannot know without the benefit of hindsight. We also do not know whether anti-monopolistic sentiment by the woke generation or looming and tighter regulation will be akin to a whiff of wind.

However, we do know that Forrest Gump’s mum exercised great wisdom:

«Life is like a box of chocolates. You never know what you're gonna get.»5
—Forrest Gump’s «momma»

That we know.

Alexander Ineichen

Alexander Ineichen is the founder of Ineichen Research and Management AG, and has been a CAIA Association member since 2003. He started his financial career in origination of risk management products at Swiss Bank Corporation in 1988. From 1991 to 2005, he had various research functions within UBS Investment Bank in Zurich and London related to equity derivatives, indices, capital flows, and alternative investments. Mr. Ineichen has written extensively on investment topics. He is the author of the two popular UBS research publications, «In Search of Alpha-Investing in Hedge Funds» (October 2000) and «The Search for Alpha Continues-Do Fund of Hedge Funds Add Value?» (September 2001), as well as two books, Absolute Returns-The Risk and Opportunities of Hedge Fund Investing (Wiley Finance, 2002) and Asymmetric Returns-The Future of Active Asset Management (Wiley Finance, 2006). He is also the author of AIMA’s «Roadmap to Hedge Funds» that has been published in 2008 and updated in 2012. Mr. Ineichen holds the Chartered Financial Analyst (CFA) and the FRM designations.
Alexander Ineichen is the founder of Ineichen Research and Management AG, and has been a CAIA Association member since 2003. He started his financial career in origination of risk management products at Swiss Bank Corporation in 1988. From 1991 to 2005, he had various research functions within UBS Investment Bank in Zurich and London related to equity derivatives, indices, capital flows, and alternative investments. Mr. Ineichen has written extensively on investment topics. He is the author of the two popular UBS research publications, «In Search of Alpha-Investing in Hedge Funds» (October 2000) and «The Search for Alpha Continues-Do Fund of Hedge Funds Add Value?» (September 2001), as well as two books, Absolute Returns-The Risk and Opportunities of Hedge Fund Investing (Wiley Finance, 2002) and Asymmetric Returns-The Future of Active Asset Management (Wiley Finance, 2006). He is also the author of AIMA’s «Roadmap to Hedge Funds» that has been published in 2008 and updated in 2012. Mr. Ineichen holds the Chartered Financial Analyst (CFA) and the FRM designations.

1 Clayman, Michelle (1987) «In Search of Excellence: The Investor’s Viewpoint,» Financial Analysts Journal, Vol. 43, No. 3 (May–June), pp. 54–64.

2 Speech given at the University of Missouri, 22 October 2002.

3 Foster, Richard and Sarah Kaplan (2001) «Creative Destruction: Why Companies That Are Built to Last Underperform the Market—and How to Successfully Transform Them,» New York: Currency, Random House, pp. 8-9. The term ‘creative destruction’ was coined by Joseph Schumpeter.

4 Rosenzweig, Phil (2007, 2014) «The Halo Effect – How managers let themselves be deceived,» London: Simon & Schuster, p. xii and 101. First published 2007.

5 Forrest Gump, film with Tom Hanks, 1994. Fun fact: The quote is ranked 40th in the American Film Institute's list of the top 100 movie quotations in American cinema. «I'll be back» is 37th. «We'll always have Paris» is 43rd.