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Pomona College Research Shows Beating the Stock Market May Be Easier Than Investors Think

Beating the stock market may be easier than investors think -- easy as following a popular magazine's most-admired companies list, according to new research from a Pomona College economics professor and one of his students.

Professor Gary Smith and Class of 2005 graduate Jeff Anderson set out to test an enduring piece of Wall Street conventional wisdom: that great companies often don't make for great investments. The idea is that if a company already has an excellent reputation, that knowledge is already built into its stock price, limiting the potential for big gains. Known as the "efficient markets hypothesis," this notion has gained wide acceptance over the years.

Because it is so widely disseminated and publicized, Smith and Anderson turned to Fortune Magazine's annual list of "America's Most Admired Companies" to test the hypothesis, comparing the stock market performance of the annual top 10 most-admired companies to the performance of the broader Standard & Poor's 500 index. Their research covered the period from the list's inception in 1983 to 2004, a span of 21 years, and is published in the July/August 2006 issue of Financial Analysts Journal.

The results: the most-admired companies dramatically outperformed the wider market, yielding annual returns of 17.7 percent vs. 13 percent for the S&P 500.

"It was a big surprise," says Professor Smith of the results, adding that he "re-checked and re-checked" the data as a result.

Smith and Anderson's research has the most-admired companies outperforming the S&P whether the investor purchased the stocks on the day of the magazine's publication, or 5, 10 or 20 trading days later. Their scenario has investors purchasing equal proportions of the top-10 stocks, then, when the next year's list is published, selling them to invest in the new top 10.

The researchers report that the difference in returns can't be attributed to the performance of a few standout companies. Over the 21 years, 214 different company stocks would have been purchased as part of the Fortune portfolio.

Professor Smith isn't sure why the efficient markets hypothesis failed the test, but he suspects the highly-touted companies benefit more from "scuttlebutt" -- the positive chatter about their performance -- than numbers-oriented Wall Street analysts realize.

The research started when Anderson delved into the topic, at Smith's suggestion, for a paper as part of a senior-year economics seminar. Anderson says the research experience was "a great way to cap off my four years" at Pomona, a top-ranked liberal arts college that emphasizes small classes and undergraduate research opportunities. Today, Anderson, an economics major from Mercer Island, Wash., is a portfolio administrator at Mellon Financial in Glendale, Calif.

Smith is the Fletcher Jones Professor of Economics at Pomona College and the author of more than 50 articles and several economics textbooks. He earned his B.A. in mathematics at Harvey Mudd College and his Ph.D. in economics at Yale University.