Jeremy Siegel, Ph.D. The Future for Investors

In recent weeks, I discussed the economic and investment prospects for China and India. Although I am optimistic about economic growth in both these countries, investors still must be cautious because the fastest growing countries are often the worst investments. Case in point: China. For most of the past decade its stocks have delivered horrible returns although the country's economic growth is second to none.

Why does this happen? Because the fastest growers often carry the steepest price tags. Investors' impulse to ignore price and "go for growth" turns out to be a costly mistake. I call pursuing growth for growth's sake the "Growth Trap."

Standard Oil of New Jersey vs. IBM

Evidence of the "growth trap" kept re-appearing in all my long-term studies of stock returns. Let me begin with the following scenario.

Imagine for a moment that we are capable of time travel and are in the remarkable position of being able to use hindsight to guide our investment decisions. Let's go back to 1950 and look at two companies: the old-economy oil giant, Standard Oil of New Jersey (now ExxonMobil), and a new-economy juggernaut, IBM.

In 1950, there were no computers in commercial use, but IBM researchers clearly saw their profit potential. IBM's advances in computer technology made it one of the world's fastest growing firms. In contrast, Standard Oil of New Jersey seemed like a dinosaur and the rise of atomic power threatened its very existence.

Which stock gave the best returns over the past 55 years? The rules are to buy stock in each firm, reinvest all the dividends back into new shares and hold all the shares until today.

Let me help you make your decision by showing you Table 1 below, which compares the vital growth statistics of these two firms. As you can see, IBM beat Standard Oil by wide margins in every growth measure that Wall Street uses to pick stocks: sales, earnings, dividends, and sector growth (change in market share of the technology and energy sector).

IBM's earnings per share, Wall Street's favorite stock picking criterion, grew more than three percentage points per year above the growth of Standard Oil from 1950 through 2005. As information technology advanced and computers became far more important to our economy, the technology sector rose from 3 percent of the market to 15 percent.

Growth Between 1950 and 2005

In contrast, the oil industry's share of the stock market shrunk dramatically. Oil stocks comprised over 20 percent of the value of all stocks in 1950, but fell to under 10 percent by 2005.

If a genie had whispered these facts in your ear in 1950, which stock would you have bought? If you answered IBM, you have fallen victim of the growth trap.

Although both stocks did well, investors in Standard Oil earned 14.46 percent per year on the shares from 1950 through 2005, almost 1 percent percent per year ahead of IBM's 13.09 percent return. Although this difference looks small, $1,000 invested in the oil giant in 1950 would be worth over $1,800,000 today, while $1,000 invested in IBM would be worth $867,000, less than one half the amount in Standard Oil.

The fact that the long-term return of Standard Oil beat IBM is not a result of the recent surge in oil stocks over the past two years. When I compared Standard Oil's return from 1950 through 2003, as I did in my book The Future for Investors, IBM still lagged by a significant amount.

Valuation is Key

Why did investors in Exxon do better than investors in IBM even though IBM did better in every growth category? One simple reason: IBM lost on the valuation criterion, and valuation, the price you pay for the earnings and dividends you receive, is the primary determinant of long-term investor returns.

IBM's earnings grew very rapidly, but investors expected them to do so and its price was consistently high. Investors in Standard Oil had more modest expectations and this kept its price low. Low pricing allowed investors to accumulate more shares of Standard Oil through the reinvestment of dividends and these extra shares proved to be Standard Oil's margin of victory.

During that 55 year period, the average P-E ratio of IBM was 26.4, more than twice as high as for Standard Oil. Furthermore, the average dividend yield of Jersey Standard was 5.08 percent, more than twice the 2.13 percent yield of IBM.

Because Standard Oil's price was low and it dividend yield much higher, those who bought the oil company's stock and reinvested those dividends accumulated more than 15 times the shares they started with, while investors in IBM accumulated only three times their original shares. That means that although Standard Oil's stock price performance consistently fell below that of IBM, its higher dividend yield made the oil giant the winner for investors.

It is not necessary for a company to pay all or most of its profits as dividends for this principle to work. Even if the firm decides to repurchase its shares, currently a popular strategy, the same principle applies. The lower the price, the more shares are repurchased and the faster the growth in earnings and future dividends.

Bottom Line:

Anyone who wagers on sports knows that automatically betting on the "best" team is not necessarily a winning strategy. Team A may be the best team, but if everyone else agrees and sends the odds to too high a level, you should bet on the worse team.

The same principle applies to stocks. Those that have the brightest prospects and are expected to grow the fastest are not necessarily the best investment. It all depends on the price you pay for the value you are getting. In fact, I will show in subsequent columns that it is growth relative to expectations that is the key determinant of investor returns.