THE BLOG

Here's A Hot Tip: Buy Crappy Stocks!

08/15/2007 11:06 am ET | Updated May 25, 2011

"My broker is great a finding quality stocks."

I hear this a lot from investors who believe their broker is adding value.

However, the assumption that it is a good idea to load up your portfolio with quality stocks is not the no-brainer that it appears to be.

The stocks of poorly managed companies, with bleak prospects, have historically outperformed investments in well-managed, financially healthy, companies over the long term.

One study compared the investment returns of 29 growth stocks to 29 value stocks. The growth stocks were altogether impressive on paper: great returns on total capital, on equity and on sales. In stark contrast, the value companies were pathetic performers, with poor earnings and bleak financial prospects.

So which category of stocks performed better? Not even close. Over the five year period studied, the "unhealthy" value stocks clobbered the "stellar" growth stocks with returns of 298 percent vs. 182 percent.

It is true that these unhealthy companies are more volatile and the risk of investing in any of them individually may result in significant losses. It is also true that some distressed stocks may perform badly and some healthy companies may perform well. However, there is compelling historical data that, on balance, the quest for a broker who can find "quality stocks" is not a search likely to result in superior returns.

Before you run out and load up on small and value-oriented funds for your portfolio, you should be aware that there have been significant periods of time when large growth stocks have significantly out-performed these sectors. Nevertheless, investors should consider, as a part of a globally diversified portfolio, tilting the stock portion of their portfolios towards domestic and international small-cap value, and large-cap value, low cost, index funds or Exchange Traded Funds, when comparable index funds are not available.

Is it likely that your broker will give you this advice? No.

And since we are on the subject of "No" -- that is still the answer I give when asked whether investors are well served by most brokers and investment advisors.

When the securities industry puts the interests of its customers ahead of its lust for fees, and focuses on capturing market returns through the use of low-cost index funds and appropriate asset allocation, my views will change.

Until then, I agree with Paul Samuelson, the first American to win the Nobel Prize in economics, who stated: "It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office."

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The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.