The Future for Investors Is Bright

Investors ought to listen to Jeremy Siegel.

The Wharton finance professor has written a new book, “The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New,” and once again, he’s doing investors a service and making Wall Street professionals very uncomfortable. Siegel has even declared an important change in his own philosophy. “The Future for Investors” is the talk of Wall Street, and it could lead to a major shift in investors’ attitudes.

Fans of Siegel already recognize him as one of the sharpest observers of the stock market. Five years ago, right as the NASDAQ bubble peaked, he wrote an op-ed for the Wall Street Journal titled “Big-Cap Tech Stocks Are a Sucker’s Bet.” It was a message that many didn’t want to hear. The article actually earned him hate mail, but few investment opinions have been so vindicated by history. Within three years, the NASDAQ lost three-fourths of its value. Investors who listened to Siegel could have saved themselves from huge losses.

His argument wasn’t particularly novel at the time. Many others had questioned the NASDAQ’s meteoric rise. But this time, the warning signal came from a man who made his reputation as an advocate of “buy-and-hold” investing.

In 1994, Siegel’s first book “Stocks for the Long Run,” showed that if you waited long enough, stocks have historically been the best asset class to own—even after adjusting for risk. Of course, for most people, the “waiting long enough” is the hard part. The book was a surprise hit and it helped launch index funds into mainstream of investing. Today, over $1 trillion is tied to indexing.

In his new book, Siegel has made an important change: He now thinks you can beat the indexes. But the key is not focusing on the fastest-growing companies, but instead, buying the “tried-and-true.” His research shows that Wall Street’s stalwarts have done better than its upstarts. In fact, he thinks that the fastest-growing stocks are often the ones you most ought to avoid. As you might imagine, this book is not sitting well within the growth-obsessed canyons of Wall Street.

For the book, Siegel completed a mammoth research project delving into the total return of the entire S&P 500, stock-by-stock, since 1957. He found that the stocks with the best total return—capital gains and reinvested dividends—were not the companies with the fastest growing profits. The top-performing stocks were often relatively dull companies in mature industries.

For example, Siegel compared the stocks of IBM and Standard Oil of New Jersey (now ExxonMobil). For decades, IBM was synonymous with growth. In the eyes of investors, IBM wasn’t merely a company—it was “the future” in corporate form. Standard Oil, on the other hand, was a dinosaur, a busted trust making-do in the computer age.

Since 1950, IBM has outpaced Standard Oil in nearly every aspect of business performance. IBM grew faster (per-share) in terms of revenue, earnings and dividends. Yet, Standard Oil gave investors a better return for their money. How could this be?

The reason, says Siegel, all comes down to valuation. Investors simply paid too much for IBM. Siegel doesn’t think this was just one misjudgment. He believes investors routinely pay too much for growth. Siegel calls this the “growth trap,” and by avoiding it, he thinks investors can do what they’ve been told they can’t—beat the averages.

Seigel’s insight is that growth alone doesn’t translate into returns. Consider these facts: Since 1957, the railroad sector has shrunk from representing 21% of the S&P 500, to just 5% today. Yet, railroad stocks have actually outpaced the index. Financial stocks have grown from 1% of the S&P 500 to over 20% today, and they’ve underperformed the index. But everyday investors are told to invest in fields like biotechnology because “it’s the future.” While it may be the future, investors aren’t being told that it may not be the best investment to make for the future.

Siegel found that the firms that have been added to the S&P 500 have actually diluted the index’s performance. Even the 20 largest stocks in the S&P have outperformed the rest of the index. And the returns of initial public offering have been “dreadful.”

Mind you, Siegel isn’t saying that emerging companies aren’t growing, but he argues that their share prices routinely fail to live up to expectations. The growth trap isn’t limited to stocks either. He says it can induce investors to overpay for investing in emerging countries as well.

Siegel examines why investors continually fall for the growth trap. One of reasons investors ignore the “tried-and-true” is that they overlook the importance of dividends. Without reinvesting dividends, the after-inflation return of the stock market drops by one-third. In the case of Standard Oil and IBM, the computer company had far greater capital gains. But it was reinvested dividends that tilted the race to Standard Oil.

Siegel found that the stocks with the highest dividend yields performed the best over the long-term. Despite the common belief that high yields are a sign of slow growth, Siegel found that many companies like Crane, Royal Dutch, Hershey and Wrigley all delivered solid growth while paying out above-average dividends. He also found that stocks with low price/earnings ratios consistently did better than stocks with higher multiples.

What about the current S&P 500? I looked at the 200 largest stocks in the index to see if I could find my own list of tried-and-true stocks. My first step was to cut out all the stocks with a price/earnings ratio greater than 15. Siegel says that, “The first mistake people make is paying too much for a stock. They think price is secondary and that ‘growth will bail me out.’ They’re wrong.”

After that, I removed all the stocks with a dividend yield under 3%. I was left with a list of 20 bargain-priced Wall Street stalwarts.

Included in this group was Altria (formerly Philip Morris) which was hardly a surprise. Siegel identifies it as the single best-performing S&P stock since 1957. Investors made nearly 20% a year in Altria. Today, the tobacco giant trades at just 14.3 times earnings while its dividend yields a generous 4.3%. That’s more than you get with a 10-Year Treasury bond.

Merck is another stock with an impressive history that made it onto my list. According to Siegel, it’s the seventh top-performing S&P stock since 1957. The shares have been severely punished lately. Merck’s stock is down over 65% since late-2000. Despite the price wreckage, the company has not only continued to pay a dividend, it has increased its payout each year. Merck currently trades at 14 times earnings, and it boasts a dividend yielding 4.7%.

I wasn’t surprised that no tech stocks made the cut, but I was surprised to see that half the members of the list were financial stocks. They don’t come more tried-and-true than Citigroup. The financial services titan earned more than $17 billion last year, but the stock is only going for 14.5 times earnings and the dividend yields 3.7%. The other financials stocks are Washington Mutual, Bank of America, BB&T, Keycorp, National City, PNC Financial, U.S. Bancorp, Wachovia and Wells Fargo (a favorite of Warren Buffett).

In 1957, the largest stock on the market was AT&T. If all the descendents were brought together again, it would still be the most valuable company in the world. Two of Ma Bell’s many spin-offs, Verizon and Bellsouth, make it onto the list.

The company with the lowest price/earnings ratio on the list is Ford Motor, which goes for just 7.3 times earnings. High oil prices have hurt American carmakers. Ford’s stock is down over 30% this year and it currently yields 4%. According to Siegel’s research, Ford has been another market-beater over the long haul.

On the opposite end of high oil prices is ChevronTexaco. As fuel prices have climbed, so have the company’s profits. Perhaps the market thinks its earnings are unusually high, which often happens to cyclical stocks. The company trades with a price/earnings ratio of just 8.3, and it pays a 3.1% dividend.

Also on the list are two utilities, Duke Energy and American Electric Power. Both yield 3.9%. The market has been rewarding utility stocks lately as investors have become more defensive. The remaining two stocks on the list are Weyerhaeuser (forestry) and Sara Lee (consumer goods).

Of course, none of these stocks is a guaranteed winner. The economy changes rapidly, and new technologies displace well-entrenched companies. Siegel also points out that we’re going through a demographic revolution. He devotes the second half of his book to the impact of demographics on our financial system. While many other authors predict doom, Siegel thinks changing demographics will help save our financial system, especially the emerging economies of the Third World.

Five years after the worst market crash since the Great Depression, it’s refreshing to hear an optimistic voice. Siegel’s thesis is certainly controversial and will be debated in the coming months and years. But now that the Federal Reserve has raised interest rates at eight straight meeting, and Greenspan has warned of “froth” in the real estate market, and Goldman Sachs said that oil could jump to over $100 a barrel, it’s wise for investors to focus on the opening line of Siegel’s book: “The future for investors is bright.”

Posted by on September 1st, 2005 at 11:21 pm


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