In search of information content: portfolio performance of The 100 Best Stocks to Own in America

Financial Services Review,  Summer 2005  by Anderson, Randy I,  Loviscek, Anthony L

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Abstract

Now in its seventh edition, The 100 Best Stocks to Own in America is an enduring and lucid reference for the active individual investor. Through the sixth edition, it had reportedly sold over 300,000 copies, indicating that it might contain information content, or stocks that can beat a broad market index on a risk-adjusted basis. Does it? As a response, we compare the out-of-sample Sharpe ratios of 30 portfolios constructed from the first six editions of Walden's rankings to the Sharpe ratios of the S&P 500. We find some evidence of information content and suggest that the individual investor focus on the top five stocks. © 2005 Academy of Financial Services. All rights reserved.

JEL classification: G14

Keywords: Information content; Portfolio; 100 stocks

1. Introduction

Active stock portfolio management requires an effective stock selection strategy. Although the theory of efficient markets suggests that the search for an effective strategy is futile, the individual investor might easily infer otherwise from the wide variety of sources that recommend stocks and stock selection strategies, as found, for example, in Barren's, Business Week, U.S.A. Today, The Wall Street Journal, "Louis Rukeyser's Wall Street," Value Line's investment Survey, S&P's STAR Ranking, the Hulbert Financial Digest, The Inefficient Stock Market: What Pays Off and Why (Haugen, 2002), and The 100 Best Stocks to Own In America (Walden, 2002).

Many researchers find that these sources do not contain information content; namely, stocks or stock selection strategies that can beat a broad market index on a risk-adjusted basis. For example, Desai and Jain (1995) cannot find much evidence of it in a time series study of Barren's Annual Roundtable recommendations. Bauman, Conover, and Cox (2002), analyzing Business Week's small stock recommendations, find negative returns after the publication date. Walker and Hatfield (1996) show that the recommendations of analysts may have some information content but that investors who follow them in the "Market Highlights" section of U.S.A. Today are likely to earn inferior returns even before accounting for transactions costs. Metrick (1999) concludes that investment newsletters do not contain superior stock selections beyond what would be expected by chance. Beltz and Jennings (1997), in studying the impact of the television program "Louis Rukeyser's Wall Street" (formerly "Wall Street Week With Louis Rukeyser"), find little evidence of superior performance-even discovering negative performance-from following the recommendations on the program, the same conclusion that Pari (1987) reaches in an earlier study. Liang (1999) shows that the impact of the Wall Street Journal's "dartboard" column on stock prices is temporary and driven by noise trading. Ferraro and Stanley (2000), using the Sharpe (1966) ratio, conclude that analysts participating in the "dartboard contest" did not beat either a random selection of stocks or the Dow Jones Industrial Average. Chandy, Peavy, and Reichenstein (1993) demonstrate that the Value Line "Stock Highlight" has a positive, but only temporary, impact on stock prices. Choi (2000), in a study of Value Line's ability to identify stocks with superior profit potential, concludes that abnormal profits are likely to be insignificant after accounting for transactions costs. Weigand, Belden, and Zwirlein (2004), using mutual fund data supplied by Morningstar, find that the top holdings among large-cap mutual funds are not likely to produce superior performance.

Other researchers, however, draw different conclusions. For example, Palmon, Sun, and Tang (1994) find evidence of persistent abnormal returns from Business Week's "Inside Wall Street." Adranji, Chatrath, and Shank (2002), in another test of the Wall Street Journal's "dartboard," discover that the risk-adjusted performances of the portfolios of stocks chosen by the stock-picking analysts consistently outperformed those of the randomly selected stocks, the Dow Jones Industrial Average, and the S&P 500. Ferreira and Smith (2003), adjusting for potential bias in event study methods, conclude that the recommendations in the 1997 broadcasts of "Louis Rukeyser's Wall Street" led to excess returns for up to eight quarters. Porras and Griswold (2000), using multifactor modeling, assert that the well-known Value Line enigma continues to hold, attributing it to Value Line's accurate assessment of stocks that are expected to perform poorly. Peterson and Peterson (1995) uncover a permanent price change in the price of stocks included in Value Line's "Stock Highlight" section. Schadler and Eakins (2001) show that Morningstar's cell classification system can guide the assessment of an individual investor's relative risk tolerance, and conclude that stocks from the low-risk categories have the largest wealth enhancement potential. Mulugetta, Movassaghi, and Zaman (2002) find evidence of abnormal returns for stocks that received a large change in rating by S&P 500.