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"Good" companies do not necessarily make good investments. A portfolio of "unexcellent" companies (chosen on the basis of financial ratios) outperformed the S&P 500 by 12% per year from 1981 to 1985, whereas a portfolio of "excellent" companies outperformed the index by only 1% per year. Over the 1988-92 period, once again, the "good" companies' financial ratios deteriorated while the "poor" companies' ratios improved. As investment portfolios, however, the good companies outperformed the S&P 500 over the period, producing a monthly alpha of 0.38%. The poor companies underperformed, producing a monthly alpha of -0.07%. There appears to be a tradeoff between growth and profitability versus valuation ratios. While good companies do not necessarily make good investments, the market appears to reward profitable companies selling at reasonable multiples.
Financial Analysts Journal © 1994 CFA Institute