Jeremy Siegel is a smart man. He is a professor of finance at the prestigious Wharton business school at the University of Pennsylvania. With a resume that boasts degrees from MIT and Columbia, Siegel isn’t called the “Wizard of Wharton” for no reason.

Last week, I picked up a copy of his book The Future for Investors. I was intrigued. Siegel doesn’t tout the hot technology stocks or hyper-growth IPOs. In fact, his philosophy is rather Buffett-esque. That’s why Siegel explains “why the tried and the true triumph over the bold and the new.”

In his book, Siegel makes a compelling case for avoiding growth stocks. In the chapter on the Growth Trap, he quotes Ben Graham: “The speculative public is incorrigible. It will buy anything at any price, if there seems to be some ‘action’ in progress. It will fall for any company identified with ‘franchising’ computers, electronics, science, technology or what have you when the particular fashion is raging.”

That’s what the growth trap does — it seduces investors into overpaying for innovation and technology companies. “The relentless pursuit of growth — through buying hot stocks, seeking exciting new technologies or investing in the fastest-growing countries — dooms investors to poor returns. In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.”

To illustrate the growth trap, Siegel uses an example. Imagine that you can time travel and are capable of hindsight to make your investment decisions. Now go back to the year 1950 and pick a stock that you will want to hold till today. You have to choose between IBM and Standard Oil of New Jersey (now ExxonMobil).

Which stock should you buy?

Remember, you’ve traveled back to 1950 to make this decision. Invention and innovation were transforming our society. Paper Mate had just developed the first leak-proof ballpoint pen. Haloid had invented the first copy machine (now Xerox). Diner’s Club introduced something called a credit card. And Bell Labs had just made the transistor, an important component of the computer revolution.

According to Siegel, “The future looked so bright that the term ‘new economy,’ so often bandied about during the 1990s technology boom, was also used to describe the economy 50 years earlier.”

Now that we’ve looked at a bit of history, let’s review some growth rates to help you decide if you should invest in IBM or Standard Oil of New Jersey.

ANNUAL GROWTH RATES, 1950-2003

Growth Measures          IBM          Standard Oil of NJ          Advantage

Revenue per Share         12.19%                 8.04%                        IBM

Dividends per Share        9.19%                  7.11%                        IBM

Earnings per Share        10.94%                 7.47%                        IBM

Sector Growth               14.65%               -14.22%                       IBM

Using the above numbers (all of which are used by Wall Street analysts to pick stocks), Siegel compares IBM with Standard Oil of New Jersey. As the information technology sector began to grow in the 1950s, its market share rose from 3% in 1950 to almost 18% in 2000. The oil industry, on the other hand, was struggling. Oil stocks comprised 20% of market value in 1950, but by 2000, they fell to just 5%.

Then Siegel asks:

“If a genie had whispered these facts in your ear in 1950, would you have placed your money in IBM or Standard Oil of New Jersey?

“If you answered IBM, you have fallen victim to the growth trap.

“Although both stocks did well, investors in Standard Oil earned 14.42% per year on their shares from 1950-2003, more than half a percentage point ahead of IBM’s 13.83% annual return. Although this difference is small, when you opened your lockbox 53 years later, the $1,000 you invested in the oil giant would be worth over $1,260,000 today, while $1,000 invested in IBM would be worth $961,000, 24% less.”

Why did Standard Oil beat IBM despite IBM’s greater growth prospects? “One simple reason: valuation, the price you pay for the earnings and dividends you receive,” Siegel explains.

Even though IBM had better growth, Standard Oil had better valuations. And valuations, NOT growth, determine investor returns. Look at this table from the book The Future for Investors…

AVERAGE VALUATION MEASURES, 1950-2003

Valuation Measures          IBM        Standard Oil of NJ        Advantage

Average P/E                      26.76                  12.97                  Standard Oil

Average Dividend Yield       2.18%                 5.19%                 Standard Oil

You can see that Standard Oil’s P/E was less than half of that of IBM’s. Standard Oil’s dividend yield was also higher.

Siegel explains an important point using these data: “Dividends are a critical factor driving investor returns. Because Standard Oil’s price was low and its dividend yield much higher, those who bought its stock and reinvested the oil company’s dividends accumulated almost 15 times the number of shares they started out with, while investors in IBM who reinvested their dividends accumulated only three times their original shares.”

So remember, long-term investment results depend not on growth rates, but rather on how much you pay for that growth. And instead of chasing high growth, focus on valuations and reinvesting dividends. You will see why the tried and true triumph over the bold and new.

Regards,

Sala Kannan
April 21, 2006

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

View articles by Penny Sleuth Contributor