Buy What You Hate

Which is the better stock: the company with a good reputation or the one with a bad one?

In corporate America, a good name can be golden. CEOs and advertising executives love to speak of the company’s image as an asset every bit as valuable as its factories and distribution systems. But does a company’s reputation actually help investors? Perhaps, but not in the way you think.

Harris Interactive and the Reputation Institute just released their annual reputation poll results. The two groups ask 7,000 people to name two companies with the best reputation and two companies with the worst. They then compile a roster of 60 companies and ask another group of people to evaluate the individual companies on attributes such as the quality of their products and services, financial performance, and social responsibility. The result is a Reputation Quotient (RQ).

You’d think that, generally speaking, it’s better to invest in a company that has a great reputation than in a company that finishes last in reputation surveys. But—at least in the relatively short-term—the market tends to agree with noted securities analyst Joan Jett, who famously proclaimed, “I don’t give a damn ‘bout my bad reputation.” After all, many of the goody-goody companies that top the reputation survey have been stock market laggards in recent years, while many of the delinquents have outperformed.

Charles Fombrun, the founder of the Reputation Institute, notes that his surveys have uncovered anti-capitalist feelings in a large chunk of the population: “When we do detailed analysis of public perception, we find that a significant portion of the ranking is negatively affected when companies do too well.” Companies that appear to profit at the expense of others do especially poorly. That might explain why Exxon Mobil, which in October reported the best quarter—ever—checks in at 53rd of 60. And why it is joined near the bottom by Royal Dutch/Shell (54), Halliburton (57), and Chevron Texaco (47).

There’s another factor that weighs against Exxon Mobil. While stock investors are focused intently on the future, reputation rankers seem to be focused on the past. The 1989 Exxon Valdez disaster still casts a pall over Exxon Mobil’s public image. The three companies at the bottom of this year’s list—MCI, Enron, and Adelphia—don’t even really exist as independent entities anymore, but they are still hated. Being associated with criminal activity or a scandal is enough to keep a company’s reputation low, even if it primarily involved a company executive—and not the company’s operations. As evidence, check out the low rankings of Tyco (55) and Martha Stewart Living Omnimedia (52).

Also, Fombrun notes, some companies just have a difficult time building positive images because of the nature of their business. “Airlines can’t do very much to make the world like them, except Southwest,” said Fombrun. “And the banks always have a hard time getting up there. They tend to be associated with gouging or taking advantage of the consumer.”

This state of affairs—a frustration for a CEO and a disaster for public relations officials—creates opportunity for investors. For the best-loved companies don’t always make good investments. Look at the companies topping the reputation chart. The top 10 are Johnson & Johnson, Coca-Cola, Google, UPS, 3M, Sony, Microsoft, General Mills, FedEx, and Intel. Of those, only Google, Federal Express, and Intel have outperformed the S&P 500 over the past three years. In the past year, only Google, Intel, and Johnson & Johnson have outperformed the S&P 500. Now look at the bottom of the reputation list. Of the six publicly traded companies in the last 11—Altria, Martha Stewart, Exxon Mobil, Royal Dutch/Shell, Tyco, and Halliburton—five have outperformed the S&P 500 over the past three years, and four have outperformed the index over the past year.

In the past, Fombrun and his colleagues have looked at the stock performance of the companies in the year following the rating. And he concludes that the companies with the best reputation tend to behave like growth stocks: “If the stock market was growing, those with high reputations tended to do better than companies with lower reputations.” But if the broader market was falling, the high-reputation stocks fell harder and faster.

Intuitively, it makes sense that highly respected companies are overvalued in hot markets. Value investors school themselves to look for stocks that are hated by the market and to avoid stocks that are loved too much by the market. When everybody owns a stock and all the analysts rate it a buy, a stock’s value tends to rise—and there’s frequently nowhere for it to go but down. Conversely, when analysts rate a stock as sell and many fewer people own it, the stock may be on the verge of failure—or it may be on the brink of a turnaround. And therein lies the opportunity. Sears Holdings, which owns the much-hated brands Sears and Kmart, has long suffered from a poor reputation. Shoppers and investors alike avoided both chains. But the widespread shunning of the company allowed hedge fund manager Eddie Lampert to gain control of Sears and Kmart on the cheap and to engineer a surprising turnaround. The stock has soared in recent months and has performed better than that of the better-regarded retailers on the list such as Costco (18), Target (25), and Wal-Mart (29).

The lesson in these choppy days may be: Find a company you really hate, and buy.