Indeed, the invention of new technologies has enabled thousands of inventors and entrepreneurs—from Thomas Edison to Bill Gates—to become fabulously wealthy by forming public companies. The corporations that Edison and Gates founded—General Electric and, a century later, Microsoft Corp.—are now ranked number one and two in the world in market value, having a combined capitalization in excess of half a trillion dollars.
Because investors see the enormous wealth of innovators like Bill Gates, they assume they must seek out the new, innovative firms and avoid the older firms that will eventually be upended by advancing technologies. Many of the firms that pioneered automobiles, radio, television, and then the computer and cell phone have not only contributed to economic growth, but also become very profitable. As a result, we set our investment strategies toward acquiring these ground-breaking firms that vanquished the older technologies, naturally assuming our fortunes will increase as these firms profit.
The Growth Trap
But all the assumptions behind these investment strategies prove false. In fact, my research shows that exactly the opposite is true: not only do new firms and new industries fail to deliver good returns for investors, but their returns are often inferior to those of companies established decades earlier.
Our fixation on growth is a snare, enticing us to place our assets in what we think will be the next big thing. But the most innovative companies are rarely the best place for investors. Technological innovation, which is blindly pursued by so many seeking to “beat the market,” turns out to be a double-edged sword that spurs economic growth while repeatedly disappointing investors.
Who Gains—and Who Loses?
How can this happen? How can these enormous economic gains made possible through the proper application of new technology translate into substantial investment losses? There’s one simple reason: in their enthusiasm to embrace the new, investors invariably pay too high a price for a piece of the action. The concept of growth is so avidly sought after that it lures investors into overpriced stocks in fast-changing and overly competitive industries, where the few big winners cannot begin to compensate for the myriad of losers.
I am not saying there are no gains to be reaped from the creative process. Indeed, there are many who become extremely wealthy from creating the new. If this were not so, there would be no motivation for entrepreneurs to develop pathbreaking technologies nor investors to finance them.
Yet the benefits of all this growth are funneled not to individual investors but instead to the innovators and founders, the venture capitalists who fund the projects, the investment bankers who sell the shares, and ultimately to the consumer, who buys better products at lower prices. The individual investor, seeking a share of the fabulous growth that powers the world economy, inevitably loses out.
History’s Best Long-term Stocks
To illustrate the growth trap, imagine for a moment that we are investors capable of time travel, so we are in the remarkable position of being able to use hindsight to make our investment decisions. Let’s go back to 1950 and take a look at two companies with an eye toward buying the stock of one and holding it to the present day. Let’s choose between an old-economy company, Standard Oil of New Jersey (now ExxonMobil), and a new-economy juggernaut, IBM.
After making your selection and buying the stock, you instruct the firm to reinvest all cash dividends back into its shares, and you put your investment under lock and key. This is an investment that will be opened a half century later, the shares to be sold to fund your grandchild’s education, your favorite charity, or even your own retirement, if you make this choice when you are young.
Which firm should you buy? And why?
THE ECONOMY AT MIDCENTURY
The first question you might have asked back in 1950 is: which sector of the economy will grow faster over the second half of the twentieth century, technology or energy? Fortunately, a quick review of history readily provides the answer. Technology firms were poised for rapid growth.
Not unlike today, the world in 1950 stood at the edge of tremendous change. U.S. manufacturers had shifted from munitions to consumer products, with technology leading the way. In 1948 there were 148,000 television sets in American homes. By 1950 that number had risen to 4.4 million; two years later, the figure was 50 million. The speed of penetration of this new medium was phenomenal and far exceeded that of the personal computer in the 1980s or the Internet in the 1990s.
Innovation was transforming our society, and 1950 was a hallmark year of invention. Papermate developed the first mass-produced, leak-proof ballpoint pen, and Haloid (later renamed Xerox) developed the first copy machine. The financial industry, already a heavy user of technology, was about to take a great leap forward as Diner’s Club introduced the first credit card in 1950. And Bell Telephone Laboratories, a branch of the largest corporation on earth, American Telephone & Telegraph, had just perfected the transistor, a critical milestone that led to the computer revolution.
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 fifty years earlier. Fortune magazine celebrated its twenty-fifth anniversary in 1955 with a special series devoted to “The New Economy” and the remarkable growth of productivity and income that America had achieved since the Great Depression.
IBM OR STANDARD OIL OF NEW JERSEY?
Let me give you some other information to help you make your decision. Look at Table 1.1, which compares the vital growth statistics of these two firms. IBM beat Standard Oil by wide margins in every growth measure that Wall Street uses to pick stocks: sales, earnings, dividends, and sector growth. IBM’s earnings per share, Wall Street’s favorite stock-picking criterion, grew more than three percentage points per year above the oil giant’s growth over the next fifty years. As information technology advanced and computers became far more important to our economy, the technology sector rose from 3 percent of the market to almost 18 percent.
TABLE 1.1: ANNUAL GROWTH RATES, 1950–2003
In contrast, the oil industry’s share of the market shrunk dramatically over this period. Oil stocks comprised about 20 percent of the market value of all U.S. stocks in 1950, but fell to less than 5 percent by year 2000. This shrinkage occurred despite the fact that nuclear power never attained the dominance expected by its advocates and the world continued to be powered by fossil fuels.
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 percent per year on their shares from 1950 through 2003, more than half a percentage point ahead of IBM’s 13.83 percent annual return. Although this difference is small, when you opened your lockbox fifty-three 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 percent less.
WHY STANDARD OIL BEAT IBM: VALUATION VERSUS GROWTH
Why did Standard Oil beat IBM when it fell far short in every growth category? One simple reason: valuation, the price you pay for the earnings and dividends you receive.
The price investors paid for IBM stock was just too high. Even though the computer giant trumped Standard Oil on growth, Standard Oil trumped IBM on valuation, and valuation determines investor returns.
As you can see in Table 1.2, the average price-to-earnings ratio of Standard Oil, Wall Street’s fundamental yardstick of valuation, was less than half of IBM’s ratio, and the oil company’s average dividend yield was more than three percentage points higher.
TABLE 1.2: AVERAGE VALUATION MEASURES, 1950–2003
A very important reason that valuation matters so much is the reinvestment of dividends. 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 fifteen times the number of shares they started out with, while investors in IBM who reinvested their dividends accumulated only three times their original shares.
Although the price of Standard Oil’s stock appreciated at a rate that was almost three percentage points a year lower than the price of IBM’s stock, its higher dividend yield made the oil giant the winner for investors. You can find the source of total returns to investors in IBM and Standard Oil of New Jersey in Table 1.3.
The basic principle of investor return that I explain in Chapter 3 states that the long-term return on a stock depends not on the actual growth of its earnings but on how those earnings compare to what investors expected. IBM did very well, but investors expected it to do very well, and its stock price was consistently high. Investors in Standard Oil had very modest expectations for earnings growth and this kept the price of its shares low, allowing investors to accumulate more shares through the reinvestment of dividends. The extra shares proved to be Standard Oil’s margin of victory.
TABLE 1.3: SOURCE OF RETURNS OF IBM AND STANDARD OIL OF NJ, 1950–2003
Stocks and Long-term Returns
Standard Oil of New Jersey is not the only “old economy” firm that proved a winning long-term investment.
In Table 1.4 you will find a list of the fifty largest American stocks trading in 1950, ranked by market value. These stocks constituted about half of the total value of all stocks traded on U.S. exchanges, which at that time dominated the world’s equity markets. If you had to pick the four best stocks to lock up for the next fifty years, which would you buy? Assume, as before, that you reinvest all dividends and hold all spin-offs and other stock distributions, never selling a single share. Your goal is to maximize your nest egg when you open up your lockbox half a century later.
Surprisingly, despite all our knowledge of what has transpired in the second half of the twentieth century, identifying the firms that have provided investors with the best returns is not an easy task. Most of those on that list were old-economy industrial firms that have either gone out of business or are in declining industries. In 1950 manufacturing accounted for almost 50 percent of the market value of the top fifty firms, while today it constitutes less than 10 percent.
Do you think Standard Oil of New Jersey or IBM made the top four? Or would you choose General Electric, the only firm of the original Dow Jones industrials that is still a member of this venerable index today? GE has kept abreast of the changing economy by diversifying out of manufacturing and developing the financial powerhouse GE Capital and the media giant NBC.
Or you might even choose the original American Telephone & Telegraph, recognizing that under the conditions of this exercise you would also own all of the fifteen firms that AT&T subsequently spun off. Back in 1950, Ma Bell, as the firm was affectionately called, was by far the most highly valued company on earth. Today, surprisingly, the aggregate market value of AT&T and all of its distributions—the huge Bell regional operating companies and all its wireless, broadband, and cable offshoots—would still exceed that of any other firm on earth.
But neither AT&T, GE, nor IBM makes the grade. The four firms with the best investor returns from 1950 through 2003, shown in Table 1.5, are National Dairy Products (later named Kraft Foods), followed by R.J. Reynolds Tobacco, Standard Oil of New Jersey, and Coca-Cola.
TABLE 1.4: FIFTY LARGEST AMERICAN COMPANIES, 1950
When the lockbox is opened fifty-three years later in December 2003, an investor who put $1,000 in each of these stocks would have accumulated nearly $6.3 million, almost six times the $1.1 million that would have accumulated if the same $4,000 were instead invested in a stock market index.
None of these top-returning stocks operated in a growth industry or at the cutting edge of the technological revolution. In fact, these four firms produce almost the identical goods that they turned out a half century ago. Their products include name-brand foods (Kraft, Nabisco, Post, Maxwell House), cigarettes (Camel, Salem, Winston), oil (Exxon), and soft drinks (Coca-Cola). Indeed, Coca-Cola prides itself on producing its flagship drink with the same ingredients it used more than 100 years ago, acknowledging that it failed when, in April 1985, it introduced “new Coke” and strayed from its tried-and-true formula.
Each of these firms has a management that focused on what they do well and concentrated on bringing a superior product into new markets. And these companies all went global; today each of them has international sales that exceed those in the United States.
TABLE 1.5: THE BEST-PERFORMING STOCKS FOR INVESTORS, 1950–2003
The Future for Investors
The more data I analyzed, the more I realized that my findings were not isolated observations but in fact representative of much deeper forces that prevail over far longer periods and over a much wider range of stocks.
In the most important and exhaustive research project I conducted for this book, I dissected the entire history of Standard & Poor’s famous S&P 500 Index, an index containing the largest firms headquartered in the United States and comprising more than 80 percent of the market value of all U.S. stocks. This index is replicated by more investors worldwide than any other, with more than $1 trillion in investment funds linked to its performance.
What I discovered completely overturned much of conventional wisdom that investors use to select stocks for their portfolios.
• The more than 900 new firms that have been added to the index since it was formulated in 1957 have, on average, underperformed the original 500 firms in the index. Continually replenishing the index with new, fast-growing firms while removing the older, slower-growing firms has actually lowered the returns to investors who link their returns to the S&P 500 Index.
• Long-term investors would have been better off had they bought the original S&P 500 firms in 1957 and never bought any new firms added to the index. By following this buy-and-never-sell approach, investors would have outperformed almost all mutual funds and money managers over the last half century.
• Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run. In contrast to skeptics who claim that high-dividend paying firms lack “growth opportunities,” the exact opposite is true. Portfolios invested in the highest-yielding stocks returned 3 percent per year more than the S&P 500 Index, while those in the lowest-yielding stocks lagged the market by almost 2 percent per year.
• The return on stocks depends not on earnings growth but solely on whether this earnings growth exceeds what investors expected, and those growth expectations are embodied in the price-to-earnings, or P/E ratio. Portfolios invested in the lowest-P/E stocks in the S&P 500 Index returned almost 3 percent per year more than the S&P 500 Index, while those invested in high-P/E stocks fell 2 percent per year behind the index. The results were almost identical to those using dividend yields.
• The long-run performance of initial public offerings is dreadful, even if you are lucky enough to get the stock at the offering price. From 1968 through 2001, there were only 4 years when the long-term returns on a portfolio of IPOs bought at their offer price beat a comparable small stock index. Returns for investors who buy IPOs once they start trading do even worse.
• The growth trap holds for industry sectors as well as individual firms. The fastest-growing sector, the financials, has underperformed the benchmark S&P 500 Index, while the energy sector, which has shrunk almost 80 percent since 1957, beat this benchmark index. The lowly railroads, despite shrinking from 21 percent to less than 5 percent of the industrial sector, outperformed the S&P 500 Index over the last half century.
• The growth trap holds for countries as well. The fastest-growing country over the last decade has rewarded investors with the worst returns. China, the economic powerhouse of the 1990s, has painfully disappointed investors with its overpriced shares and falling stock prices.
The Upcom
ing Demographic Crisis
Will the important findings highlighted above hold true over the next fifty years?
Perhaps not, if the age wave that faces the United States, Europe, and Japan means that our future is bleak. And many believe that to be the case. There are 80 million baby boomers who own trillions of dollars in stocks and bonds that in the next several decades will have to be sold in order to fund their retirement. In Europe and Japan, the population is aging at an even more rapid rate than in the United States.
An overabundance of sellers could spell disaster for investors and retirees desperately attempting to convert their financial assets into cash that will buy goods and services. Moreover, as the baby boomers retire, the looming shortage of workers in the United States is threatening to reduce the supply of the goods that the baby boomers must have in order to enjoy a comfortable retirement.
Respected voices such as Peter Peterson, author of Running on Empty, and Larry Kotlikoff, professor of economics at Boston University and author of The Coming Generational Wars, prophesy economic doom ahead. Peterson, Kotlikoff, and others warn that the aging of the population, woefully inadequate savings rates, and a shortage of future workers will cause an economic meltdown that will destroy the retirement of millions of Americans.
I, too, believe our future will be demographically driven. But after conducting my own research into the demographic realities we face, I disagree strongly with the pessimistic conclusions cast by Peterson, Kotlikoff, and others. My own model of demographic and productivity trends has convinced me that, instead of teetering on the edge of disaster, the world is poised for accelerating economic growth.
The Future for Investors Page 2
