Wealth Building Lessons

Value stocks typically return a dividend between 2.5% to 10% depending on the industry they’re in and the prevailing market conditions. Growth stocks typically do not provide a dividend, and if they do its usually less then 2.5%. They usually retain their earnings for future growth. Many stock analysts and investors believe that returning money to shareholders means that the management is running out of ideas on how to grow the business and avoid dividend paying stocks like the plague! Personally I’m partial towards dividend-paying stocks. I especially like the Canadian Income Funds that invest in Oil and Gas.

Many people believe that choosing growth stocks will provide you with higher returns over the long run. In fact, many studies have supported this claim. Most of these studies use attributes such as market capitalization and earnings growth to prove their results. However these may not be accurate measurements since the only indicator that concerns an investor is valuation or stock price.

In his excellent book The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New, Prof. Jeremy Siegel explores the growth stock myth in more detail.

He studied the original companies in the S&P 500 Index in 1950 and found out that if you had bought the original companies and never sold them, or changed them to reflect the new companies that were added to the index, you would’ve beaten the index over the next 53 years.

Even though growth stocks like IBM beat value stocks like Standard Oil of NJ in terms of price appreciation, once you factor in dividend reinvestment, Standard Oil (with its dividend rate twice that of IBM) turned out to be the winner.

The top four performing stocks of the original S&P500 were National Dairy Products (Kraft Foods), R.J. Reynolds Tobacco, Standard Oil of NJ (Exxon Mobil) and Coca-Cola, yielding between 15.47% and 14.33% each over a 53 year period. (He concluded his research in 2003 so its 53 year period). According to Warren Buffett, you should only invest in companies who business you can explain to a six year old. All the top performers meet this criteria!

Jeremy Siegel’s studies have completely overturned a lot of the conventional wisdom that investors use to select stocks for their portfolios.

• Since 1957, over 900 new firms have been added to the S&P500 Index. Most of them have underperformed the original 500 firms in the index! Continually replacing the index with new, fast-growing companies while removing the older, established firms actually lowered the returns to investors
• Long term investors would have been better off if they had bought the original 500 stocks and never bought any new firms. This strategy would’ve enabled investors to beat the market and all money managers over the past 50 years.
• Dividend reinvestment is the critical factor in the winning stocks. Portfolios invested in the highest-yielding stocks beat the index by 3%, while those invested in the lowest yielding stocks lagged by 2%. This means that those who believe that high-yielding stocks lack growth opportunities are wrong!
• The return on stocks doesn’t depending on earnings growth, but on whether the earnings growth exceeds investor expectations. These expectations are apparent in the price-to-earnings or P/E ratio. Portfolios invested in the lowest P/E stocks returned 3% more than the index, while those invested in the highest P/E stocks lagged by 2%. (Yes, these are identical results to using dividend yields).
• The long term performance of IPOs (initial public offerings) was terrible, even if you got in at the IPO price.
• The growth trap holds true for sectors as well as individual firms. Financials, the fast growing sector, has under-performed the S&P500 index while the energy sector, which has shrunk nearly 80% since 1950 beat it! Railways, which shrunk from 21% to under 5% of the industrial sector also managed to outperform this index over the past half century. [No wonder Warren Buffett has been loading up on them].
• This growth trap affects countries too. China, the fastest growing economy of the 90s rewarded investors with the worst returns. [I guess its time to invest in Japan, which has by far the cheapest stock and real estate valuations of any developed nations!].

Along with his expert analysis, Prof. Siegel also has excellent advice for investors in different situations. He explains how to determine if you’re in a bubble and what steps to take to protect your investments. He also mentions various investment strategies to benefit from his research. Maybe I’ll explain some of them in another post, but I strongly suggest that you pick up the book at the local libray.

Related Readings:

1. The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New

2. One Up On Wall Street : How To Use What You Already Know To Make Money In The Market

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