Yahoo!
Another reason the new firms added to the S&P 500 Index underperform involves the very success of the index. It has been estimated that more than $1 trillion of investor capital is committed to funds that are linked to the S&P 500 Index. This means that when the S&P adds a firm to its index, there will be a huge and automatic increase in the demand for that stock, pushing up its price and hence lowering the return of indexed investors.8
A perfect example of an overvalued stock that became even more overvalued was Yahoo!, the leading Internet portal company. On November 30, 1999, near the peak of the Internet boom, Standard & Poor’s announced that Yahoo! would be added to its index on December 8. Up to that date, AOL, which had been admitted in January 1999, was the only Internet stock in the index.
The next morning, a flood of buy orders, prompted by the recognition that index funds would soon have to purchase substantial blocks of this stock, pushed Yahoo! up almost $9 at the opening of trading. The stock continued to rise until it closed at $174 per share on December 7. In just five trading days, the stock soared $68, or 64 percent above the price it was trading at before the S&P announcement. On December 7, the last day index funds had to buy the stock, volume hit 132 million shares, representing $22 billion of Yahoo! stock traded.
Now, I believed Yahoo! was grossly overvalued when it was selling at $106 a share, before Standard & Poor’s added the firm to its index. As I will discuss in Chapter 5, I included Yahoo! as one of the nine most overvalued large-cap stocks in an article that I published in the Wall Street Journal in March 2000. At that time Yahoo!’s market value was more than $90 billion, and the stock was selling at about 500 times earnings, more than twenty times the average for the S&P 500 Index.
Holding a substantial position in an S&P 500 Index fund at the time, I was quite distressed with the surge in Yahoo!’s price. It was clear to me that Yahoo! would drag down the future returns of the index and that this would not be the last time such an incident occurred.
Subsequent events confirmed my fears. What happened to Yahoo! was also happening to other firms added to the S&P 500 Index. In the year 2000, King Pharmaceuticals jumped 21 percent from its announcement dates to its inclusion in the S&P 500, CIT Group rose 22 percent, JDS Uniphase increased by 27 percent, Medimmune jumped 31 percent, Power One rose over 35 percent, and Broadvision rocketed up 50 percent.
All these price jumps meant that the return to popular index products could be subject to a downward bias over time. Standard & Poor’s is very aware of this situation, and in March 2004 it announced steps to reduce the price impact of being added to or deleted from the index.9 Nevertheless, it is likely there will always be a premium on S&P 500 stocks as long as the index retains its popularity.10
The Confusion Between Market Value and Investor Return
Where did Foster and Kaplan go wrong when they concluded that it was the new firms that drove the S&P 500 returns? They incorrectly used changes in the market value of a stock as a measure of investor return. Market value, which is often called market capitalization or market cap, is the product of the number of shares outstanding for a company and the price per share. For example, in 2004 there were approximately 11 billion shares of Microsoft stock outstanding. At Microsoft’s price per share of $27, Microsoft had a market capitalization of approximately $300 billion. This market cap can change if either the price of Microsoft’s stock changes or the number of shares changes.
Investor return is a very different concept. It is equal to change in the price per share plus the dividend, if there is any. The return on Microsoft will change if either the price of Microsoft stock changes or the dividend changes. The only common factor in both definitions is the price of the stock. Dividends and changes in the number of shares outstanding have a very different impact on investor returns.
Confusing investor return and market capitalization is a mistake that many other investors and even professionals make. Market value and return are indeed very tightly linked in the short run. Day to day or week to week, there is nearly a perfect correlation between the two concepts. But as the period lengthens, the correlation becomes much weaker. For a long-term investor, dividends become the primary source of investor return.
THE IMPORTANCE OF REINVESTING DIVIDENDS
Recall that the price of IBM’s shares increased at over 11 percent per year, almost three percentage points above that of Standard Oil of New Jersey, but Standard Oil’s return surpassed that of IBM. Standard Oil’s high dividend yield made a huge difference in boosting its return. The price of Standard Oil increased by a factor of about 120 from 1950 through 2003, while IBM’s price increased almost 300-fold. But shareholders who bought Standard Oil (now ExxonMobil) in 1950 and reinvested their dividends would have over fifteen times the number of shares they started with, while shareholders in IBM would only have three times the number of shares.
Many investors and advisors fail to realize the impact of reinvesting dividends on long-term performance. This neglect occurs because investors focus excessively on short-term price appreciation when they should focus on long-term returns. This is yet another manifestation of the growth trap. Investors must be patient and understand that accumulating extra shares through dividend reinvestment increases their returns. A crucial lesson for long-term investors, a lesson that will be emphasized in Part 3 of this book, is that the reinvestment of dividends matters—and it matters a lot.
FALLING MARKET VALUE AND RISING RETURNS
There are other reasons for the disconnect between market value and return. Take AT&T, which was the most valuable company in the world when the S&P 500 was founded in 1957. By the end of 1983, its market capitalization had grown to almost $60 billion. When the Justice Department ordered AT&T to divest all of its Baby Bells (regional Bell operating companies), AT&T shareholders received additional shares of seven separate companies.11
This restructuring caused AT&T’s market capitalization to plunge from $60 billion to $20 billion by the end of 1984. Yet when taking into account the divestitures, the investor return on AT&T was positive. Instead of the 66 percent decline in market value, investors who held their spin-offs saw their wealth grow by 30 percent that year.
RISING MARKET VALUE, FALLING RETURNS
But the reverse can also occur: market values can rise while returns fall. This happens when a company issues shares to finance a new project or, frequently, arranges to merge with another firm.
The largest all-stock merger in history occurred when AOL merged with Time Warner in 2000 at the peak of the technology boom. AOL issued Time Warner shareholders 1.5 shares of AOL for each Time Warner share, creating the world’s largest media company. Each AOL shareholder’s slice of the total pie shrank when these new shares were issued, but the entire pie grew larger because the two companies became one.
When the merger was complete, AOL had increased its market capitalization from $109 billion to $192 billion, making it one of the largest corporations in the world. Unfortunately for Time Warner shareholders, they were given AOL’s stock at the very peak of the market and suffered dreadful returns in the following years. By 2003, AOL Time Warner dropped the AOL name, perhaps trying to erase the bad memory of a deal gone sour.
There is also a substantial difference between the return and market value of the original and updated firms in the S&P 500 Index. The market value of the S&P 500 Index increased from $172 billion in 1957 to $10.3 trillion by December 31, 2003, a 9.13 percent annual rate. In contrast, the market value of the original firms in the index has grown at a lower 6.44 percent annual rate, reaching only $3.2 trillion by the end of 2003.
The important point is that while the market value of the survivors grew at a far lower rate than the market value of the S&P 500 Index, the return on the portfolio of survivors exceeded the return on the index. The market value of the S&P 500 increased more rapidly because all the new companies added to the index increased its market value, but these additions did not increase its retur
n. This is where Foster and Kaplan went wrong in their research and why the pursuit of growth is often the wrong investment strategy.
Should Investors Hold or Sell Spin-offs?
The historical analysis of the S&P 500 Index also sheds some light on whether investors should hold spin-offs and other stock distributions or sell them and redeploy the funds elsewhere. The difference between holding and not holding the spin-offs can be found by examining the returns on the Total Descendants portfolio and the Direct Descendants portfolio.
Solely on the basis of risk and return, there is not much to choose between them. Sometimes the spin-offs did better than the parent firm, sometimes they did not. For example, investors would have been much better off holding AT&T’s Baby Bells, whose returns were almost three percentage points per year more than those of AT&T itself. Similarly, Morgan Stanley and Allstate outperformed their parent, Sears, Roebuck. On the other hand, Praxair, a natural gas producer, failed to match the return on its parent, Union Carbide, as did the energy and gold properties spun off by Atchison, Topeka & Santa Fe Railway.
But from a tax and transaction costs standpoint, holding the spin-offs is likely to be very advantageous. By holding the Total Descendants portfolio, no shares are ever sold in the open market, and the only shares purchased arise from the receipt of dividends and other cash distributions, so that trading costs are minimized.12 Moreover, with very few exceptions, no capital gains are realized on this portfolio, as no shares are ever sold.13
Investors should not take these cost savings lightly. One of the most serious drags on investor returns comes from the transaction costs and taxes incurred by trading too much. Although the returns on these portfolios do not take these costs into account, the Total Descendants portfolio incurs lower costs than investors would in S&P 500 mutual or exchange-traded funds. The cost savings alone implies that investors would do well by holding on to all spin-offs they receive.
Lessons for Investors
Schumpeter’s concept of creative destruction fittingly describes the way capitalist economies function. New firms upstage old firms, forcing change, driving growth, and overthrowing the status quo. But the process of creative destruction works very differently in the capital markets. It is investors in the firms deemed “creative” who get hammered by paying prices for their shares that are too high.
What do these findings mean for investors? Should one just buy a portfolio of stocks such as the S&P 500 and hold it forever? The short answer is no. As we will learn in subsequent chapters, there are opportunities for investors to do even better than the returns on the portfolios of original S&P 500 firms reported here.
But the research contained in this chapter destroys the myth that updating one’s portfolio is essential to obtain superior returns. In fact, extremely popular indexes, such as the S&P 500, can lead to overpricing of newly admitted firms and lower future performance. Furthermore, “buy-and-hold” portfolios are very tax efficient and lower transaction costs and are an attractive way to build wealth in the long run.
The next chapter identifies the firms that have powered these original S&P portfolios ahead of the market.
CHAPTER THREE
The Tried and True:
FINDING CORPORATE EL DORADOS
But how, you will ask, does one decide what [stocks are] “attractive”? Most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” … We view that as fuzzy thinking.… Growth is always a component of value [and] the very term “value investing” is redundant.
—Warren Buffett, Berkshire Hathaway annual report, 1992
The last chapter summarized the long-term returns to portfolios of the original firms in the S&P 500 Index. In the appendix to this book, you will find a record of the transformation and returns of each of the original S&P 500 firms, including a detailed description of the twenty best-performing stocks from the Total Descendants portfolio and the performance of the twenty largest firms, which accounted for almost half of the market value of the index when it was founded in 1957.
These lists, including the ones described in this chapter on the best-performing surviving companies, give you an appreciation of the tremendous changes that have taken place in corporate America over the past five decades and go a long way toward answering the following questions: What firms give the best returns? What industries are they from? And most important, what characteristics make a stock a successful long-term investment?
The Corporate El Dorado: The Number-One-Performing Stock
In Creative Destruction: Why Companies That Are Built to Last Underperform the Market, and How to Successfully Transform Them, Richard Foster and Sarah Kaplan commented, “[Our] long-term studies of corporate birth, survival, and death in America clearly show that the corporate equivalent of El Dorado, the golden company that continually performs better than the markets, has never existed [emphasis in original]. It is a myth.”1
On the contrary, my research shows that not only does the corporate equivalent of El Dorado exist, but in fact there are many corporate El Dorados. Finding these firms can make a huge difference to your portfolio.
In the last chapter I showed that $1,000 placed in an S&P 500 Index fund on February 28, 1957, would have grown, with dividends reinvested, to almost $125,000 by December 31, 2003. But $1,000 placed in the top-performing company from the original S&P 500 firms would have grown to almost $4.6 million. What was this golden company that beat the market by 9 percent per year over the last half century and left every other firm far behind in the race to be number one?
It was Philip Morris, which in 2003 changed its name to Altria Group.2 Philip Morris introduced the world to the Marlboro Man, one of the world’s most recognized icons, two years before the formulation of the S&P 500 Index. Marlboro subsequently became the world’s best-selling cigarette brand and propelled Philip Morris stock upward.
Philip Morris’s outstanding performance does not just date from midcentury. Philip Morris was also the best-performing company since 1925, the date when comprehensive returns on individual stocks were first compiled. From the end of 1925 through the end of 2003, Philip Morris delivered a 17 percent compound annual return, 7.3 percent greater than the market indexes. An initial $1,000 invested in this firm in 1925, with dividends reinvested, would now be worth over a quarter of a billion dollars!
Philip Morris’s bounty did not only extend to its own stockholders. As the appendix describes in detail, Philip Morris eventually became the owner of nine other original S&P 500 firms. Many investors in such little-known companies as Thatcher Glass became enormously wealthy because their shares were exchanged for successful companies such as Philip Morris and its predecessors. Riding on the coattails of such winners is an unexpected, but not uncommon gift for investors.
How Bad News for the Firm Becomes Good News for Investors
Some readers may be surprised that Philip Morris is a top performer for investors in the face of the onslaught of governmental restrictions and legal actions that have cost the firm tens of billions of dollars and threaten the cigarette manufacturer with bankruptcy.
But in the capital markets, bad news for the firm often is transformed into good news for investors. Many shun the stock in the company and fear that its legal liability for producing a dangerous product—cigarettes—will eventually crush the firm. This aversion to the firm pushes down the price of Philip Morris shares and raises the return to investors who stick with the stock.
As long as the firm survives and continues to be very profitable, paying out a good fraction of its earnings in the form of dividends, investors will continue to do extraordinarily well. With the price of its stock so low and its profits so high, Philip Morris’s dividend yield is one of the highest in the market. Those reinvested dividends have turned its stock into a pile of gold for investors who have stayed with the company. The power of Philip Morris’s high dividend to propel its higher returns is discussed in Chapter
10.
The superb returns in Philip Morris illustrate an extremely important principle of investing: what counts is not just the growth rate of earnings but the growth of earnings relative to the market’s expectation. One reason investors had low expectations for Philip Morris’s growth because of its potential liabilities. But its growth has continued apace. The low expectations combined with high growth and a high dividend yield provide the perfect environment for superb investor returns.
Later in this chapter I will state and explain the basic principle of investor return, which will enable you to find the winning stocks. But before I do so, let us take a look at the original S&P 500 firms and determine which have performed best for investors. Once we study their characteristics, we shall be able to identify the true corporate El Dorados.
The Top-Performing S&P 500 Survivor Firms
Table 3.1 indicates the twenty best-performing surviving firms of the original S&P 500 Index in 1957. These are firms whose corporate structure remained intact, as they have not been merged into any other firms. The shareholder return on each of these companies has beaten the return on the S&P 500 Index by at least two and three-quarters percentage points per year since the index was founded in 1957, and some have beaten the index by much wider margins. This means that an investment in any of these stocks has accumulated anywhere from three to thirty-seven times the accumulation of the S&P 500 Index.
The Future for Investors Page 4
