The Future for Investors

by Jeremy J Siegel

  TABLE 3.1: TOP-TWENTY PERFORMING SURVIVORS, 1957–2003

  What strikes one immediately is the dominance of two industries: well-known consumer brand companies and large, well-known pharmaceutical firms. All these firms have built wide name recognition and consumer trust. They have survived and prospered over the past half century through significant changes in the economic and political climates, and virtually all have expanded aggressively into international markets. The success of these firms is what I call the triumph of the tried and true.

  THE POWER OF CONSUMER BRAND NAMES

  Philip Morris is one of many firms with a strong brand name that has made it to the top of the pack. In fact, eleven of the top twenty are well-known consumer brand stocks.

  As the medical, legal, and popular assault on smoking has accelerated, Philip Morris (as well as the other giant tobacco manufacturer, R.J. Reynolds) has diversified into brand-name food products. In 1985 Philip Morris purchased General Foods, and in 1988 the company purchased Kraft Foods for $13.5 billion. It completed its food acquisitions with Nabisco Holdings in 2001. Currently, Philip Morris receives more than 40 percent of its revenues and 30 percent of its profits from food products.

  The tobacco manufacturers are among the few successful long-term companies that have ventured outside their original specialty—the manufacture and sale of tobacco products. We take a closer look at the corporate evolution of Philip Morris in the appendix, where we will find that the company’s shares end up in the portfolios of investors in ten of the original S&P 500 firms, all of which beat the S&P 500 Index. But first let us take a look at some of the other consumer brand name firms on the best-performing list.

  Number four on this list is a most unlikely winner—a small manufacturer originally named the Sweets Company of America. This company has outperformed the market by 5 percent a year since the index was formulated. The founder of this firm, an Austrian immigrant, named its product after his five-year-old daughter’s nickname, Tootsie. The Sweets Company of America changed its name to Tootsie Roll Industries in 1966.3

  In 2002, Tootsie celebrated its 100th year of listing on the New York Stock Exchange. The company produces over 60 million Tootsie Rolls and 20 million lollipops per day, making it the world’s largest lollipop supplier. Remarkably, the company’s Web site proudly proclaims that the price of its flagship product (the single wrapped Tootsie Roll) has remained unchanged at one penny for the past 107 years (although I’m sure that its size has shrunk).

  The surviving company with the sixth highest return produces a product today with the exact same formula as it did over 100 years ago, much like Tootsie Roll. This company was highlighted in Chapter 1 as one of the four best-performing of the largest fifty firms from 1950. Although the company keeps the formula for its drinks secret, it is no secret that Coca-Cola has been one of the best companies you could have owned over the last half century.

  What about Coke’s well-known rival, Pepsi, which also was on the list of the original S&P 500 firms? Pepsi also delivered superb returns to its shareholders, coming in at number eight and beating the market by over 4 percent a year.

  Two others of the twenty best-performing stocks also manufacture products virtually unchanged over the past 100 years: the William Wrigley Jr. Company and Hershey Foods. Wrigley came in at number twelve, beating the market by almost 4 percent a year, whereas Hershey came in at seventeen, beating the market by 3 percent a year.

  Wrigley is the largest gum manufacturer in the world, commanding an almost 50 percent share in the global market and selling in approximately 100 countries. Hershey is currently the number-one U.S.-based publicly traded candy maker (Mars, a private firm, is number one, followed by Swiss-based Nestlé).

  Founded by Milton Hershey in 1905, Hershey Foods did not advertise its products until 1970, maintaining that its high quality would speak for itself. For years Hershey’s success showed that strong brands can be sold through word of mouth.

  Heinz is another strong brand name, one that is virtually synonymous with ketchup. Each year, Heinz sells 650 million bottles of ketchup and makes 11 billion packets of ketchup and salad dressings—almost two packets for every person on earth. But Heinz is just not a ketchup producer, and it does not restrict its focus to the United States. It has the number-one or -two branded business in fifty different countries, with products such as Indonesia’s ABC soy sauce (the second-largest-selling soy sauce in the world) and Honig dry soup, the best-selling soup brand in the Netherlands.4

  Colgate-Palmolive also makes the list, coming in at number nine. Colgate’s products include Colgate toothpastes, Speed Stick deodorant, Irish Spring soaps, antibacterial Softsoap, and household cleaning products such as Palmolive and Ajax.

  No surprise that Colgate’s rival, Procter & Gamble, makes this list as well, at number sixteen. Procter & Gamble began as a small, family-operated soap and candle company in Cincinnati, Ohio, in 1837. Today, P&G sells three hundred products, including Crest, Mr. Clean, Tide, and Tampax, to more than five billion consumers in 140 countries.

  Fortune Brands started off as a tobacco giant, American Tobacco. After it gained control of almost the entire cigarette industry, it was dissolved in an antitrust suit in 1911. The major companies that emerged from it were American Tobacco, R.J. Reynolds, Liggett & Myers, Lorillard, and British American Tobacco.

  Two of the most popular brands that remained with American Tobacco were Lucky Strike and Pall Mall. In the 1990s the company divested all tobacco products, selling its large tobacco brands privately to British American Tobacco and divesting its large stake in Gallaher Group, another British tobacco company that it had purchased earlier. Today, American Brands, renamed Fortune Brands in 1997, sells branded products such as Titleist golf balls and Jim Beam spirits.

  Number twenty on the list is General Mills, another company with strong brands, which include Betty Crocker, introduced in 1921, Wheaties (the “Breakfast of Champions”), Cheerios, Lucky Charms, Cinnamon Toast Crunch, Hamburger Helper, and Yoplait yogurt.

  What is true about all these firms is that their success came through developing strong brands not only in the United States but all over the world. A well-respected brand name gives the firm the ability to price its product above the competition and deliver more profits to investors.

  THE PHARMACEUTICALS

  Besides the strong consumer brands firms, the pharmaceuticals had a prominent place on the list of best-performing companies. It is noteworthy that there were only six health care companies in the original S&P 500 that survive to today in their original corporate form, and all six made it onto the list of best performers. All of these firms not only sold prescription drugs but also were very successful in marketing brand-name over-the-counter treatments to consumers, very much like the brand-name consumer staples stocks that we have reviewed.

  The top-performing pharmaceutical firm for investors was Abbott Laboratories, coming in second and beating the market by more than 5.5 percent per year. Since 1957, Abbott turned each $1,000 invested into $1.2 million by the end of 2003. Abbott went public in 1929 and is a leading producer of antiviral drugs, particularly those used to treat HIV/AIDS, as well as treatments for epilepsy, high cholesterol, and arthritis. In the consumer division, the company has succeeded with such nutritional supplements as Similac and Ensure as well as the best-selling acid reflux remedy, Prevacid.

  The next three successful pharmaceuticals, Bristol-Myers Squibb, Pfizer, and Merck, came in third, fifth, and seventh on the list of best-returning survivor firms. All would have turned $1,000 into roughly $1 million.

  Bristol-Myers was founded more than a century ago and in 1989 purchased Squibb, a New York drug firm that dates back to the mid-1850s. Bristol-Myers Squibb has such household name over-the-counter drugs as Excedrin and Bufferin, as well as nutritional products for children through its Mead Johnson subsidiary. Its prescription blockbusters include Prava-chol for cholesterol and the platelet inhibitor Plavix.

 
Pfizer, formed in 1900, discovered such blockbuster antibiotics as Ter-ramycin, was the producer of the Salk and Sabin polio vaccines in the 1950s, and pioneered Viagra and the cholesterol-reducing, best-selling drug of all time, Lipitor. Its consumer division features such brand names as Listerine, Benadryl, Rolaids, Ben-Gay, and many others.

  Rounding out the top twenty are Schering (later Schering-Plough) and American Home Products (renamed Wyeth in 2002), ranking number fifteen and number eighteen, respectively. Schering was a German firm seized by the U.S. government in the Second World War and then privatized in 1952. Schering pioneered antihistamines, such as Coricidin, and has had success with Tinactin, Afrin, and Coppertone, and Di-Gel from its merger with Plough in 1971.

  American Home Products developed Preparation H in the 1930s, bought Anacin, and produces such well-known over-the-counter products as Advil, Centrum, Robitussin, and others. In the pharmaceutical area, its antidepressant Effexor and sleep aid Sonata have been profitable.

  The prices of Bristol-Myers Squibb and Schering-Plough stock have declined nearly three-quarters by the end of 2003 from their peak three or four years earlier as a result of the loss of patents on some key pharmaceuticals (such as Claritin for Schering-Plough). Had these firms maintained their value, they would have ranked number two and three, right behind Philip Morris.

  When these six pharmaceuticals are added to the eleven name-brand consumer firms, seventeen, or 85 percent, of the twenty top-performing firms from the original S&P 500 Index, feature well-known consumer brand names.5

  Except for the cigarette manufacturers, which vigorously expanded into foods as cigarette consumption declined, each of these firms, with rare exceptions, was run by a management that stuck with the products it knew best and was committed to maintaining quality and expanding their markets abroad.

  Finding Corporate El Dorados: The Basic Principle of Investor Returns

  How do you find these great firms? The first step is to understand a concept called the basic principle of investor return, or BPIR. Before I formally define this principle, consider the following question. Suppose I give you the following facts. Firm A will deliver a 10 percent earnings growth rate over the next ten years, while firm B will deliver 3 percent growth. Which firm would you choose to buy?

  Many would say firm A, the one with the higher earnings growth rate. But you cannot answer the question without one more piece of critical information: what growth rate do investors expect from these two companies?

  If investors expected firm A to grow at 15 percent over the next decade while firm B was only expected to grow at 1 percent per year, you should buy firm B, not firm A. This is because firms with high growth expectations carry a high price that drags down their future returns, while firms with low growth expectations have prices low enough so that even moderate growth can lead to very good returns.

  The basic principle of investor return states:

  The long-term return on a stock depends not on the actual growth of its earnings, but on the difference between its actual earnings growth and the growth that investors expected.

  Investors will receive a superior return only when earnings grow at a rate higher than expected, no matter whether that growth rate is high or low.

  Recall the case of IBM and Standard Oil of New Jersey, discussed in Chapter 1. IBM’s earnings grew rapidly, but investors expected them to grow rapidly. Standard Oil’s earnings did not grow nearly as fast as IBM’s earnings did, but its investors had far more modest expectations, allowing Standard Oil to deliver higher returns than IBM.

  To find the corporate El Dorados and earn superior returns, your ultimate goal is to find stocks whose growth will be high relative to expectations. The best way to determine those expectations is by looking at the price-to-earnings (P/E) ratio of a stock. High P/E ratios mean that investors expect above-average earnings growth, while low P/E ratios indicate below-average growth expectations.

  VALUATION MATTERS—ALWAYS

  Expectations are so important that without even knowing how fast a firm’s earnings actually grow, the data confirm that investors are too optimistic about fast-growing companies and too pessimistic about slow-growing companies. This is just one more confirmation of the growth trap.

  Since price-to-earnings ratios are the best way to measure the growth expectations already incorporated in the price of a stock, I computed the P/E ratio on all 500 firms in the S&P 500 Index on December 31 of each year by dividing the last twelve months of earnings by the end-of-year price. I then sorted these firms by P/E ratios into five groups, or quintiles, and computed the returns of each group over the next twelve months.6

  Figure 3.1 displays the results of this research. High-P/E stocks are, on average, overvalued by the market and lead to lower returns. A $1,000 investment in 1957 in a portfolio of the highest-priced stocks accumulated to only $56,661, earning an annual return of 9.17 percent. This accumulation was less than half of the approximately $130,768 that would have accumulated in the benchmark S&P 500, which delivered an 11.18 percent annual return.

  By contrast, the lowest-priced stocks accumulated to a sum that was over three and a half times greater than the wealth accumulated in the market, earning an extraordinary 14.07 percent annual return and doing so with less risk than the S&P 500 Index.

  These results show that investors must always look at price relative to earnings when deciding what to buy. Investing by looking at growth prospects alone will trap investors into poor returns.

  FIGURE 3.1: CUMULATIVE RETURNS TO S&P 500, SORTED BY P/E RATIOS (SOURCE: COMPUSTAT®)

  VITAL STATISTICS

  Interestingly, most of the corporate El Dorados listed in Table 3.1 do not come from the lowest-P/E stocks. Table 3.2 reports the return, the average earnings per share growth and P/E ratio, and the dividend yield on the top twenty survivor companies over the period from 1957 through 2003.

  There was no question that the earnings of these winning firms grew rapidly, far faster than the earnings of the S&P 500 Index. But the average valuation of these firms, measured by the price-to-earnings ratio, was only slightly above the average stock in the index. This indicates that investors expected these firms’ earnings to grow only slightly faster than the earnings of the average stock in the S&P 500 index. The fact that the average earnings of these firms grew almost four percentage points per year above the average firm in the S&P 500 Index over nearly half a century explains their superior returns.

  Table 3.2 shows why Philip Morris beat the competition so decidedly. Its P/E ratio was among the lowest on the list, indicating expectations of low earnings growth, while its actual earnings growth was the highest. The gap between Philip Morris’s actual growth and expectations of growth was the greatest and enabled the cigarette manufacturer to produce the highest rate of return.

  DIVIDENDS MAGNIFY EFFECT

  So far we have ignored the dividend paid by the firm. But dividends are far from unimportant. In fact,

  The power of the basic principle of investor return is magnified when the stock pays a dividend.

  Consider this. If earnings are better than expected, that means that the stock is underpriced and purchasing more shares through dividend reinvestment will enhance your returns even more.7 All the firms in Table 3.2 were underpriced, so their dividend yields further enhanced their returns.

  We have now found a second reason why Philip Morris was the best-returning stock in the market. Not only was the difference between actual and expected earnings growth the highest among these twenty best-performing stocks, but the cigarette manufacturer had the fourth highest dividend yield. The high dividend yield enabled investors to purchase even more shares of Philip Morris stock. Each time Philip Morris paid its ever-rising quarterly dividend (Philip Morris has never lowered its dividend), investors were accumulating more shares of an undervalued stock.

  PEG RATIOS AND GROWTH AT ANY PRICE (GARP)

  One of the biggest advocates of searching for growth stocks at reasonab
le prices is Peter Lynch, the legendary stock picker for Fidelity’s Magellan Fund from 1977 through 1990. During those years his fund outperformed the market by an incredible 13 percent per year.

  In his best-seller One Up on Wall Street Lynch advocated a simple strategy for choosing stocks. He instructed readers to “[f]ind the long-term growth rate … add the dividend yield … and divide by the p/e ratio.… Less than a 1 is poor, and 1.5 is okay, but what you’re really looking for is a 2 or better.”8

  TABLE 3.2: VITAL STATISTICS ON THE TOP-TWENTY SURVIVORS

  Others have advocated a similar strategy called GARP, or growth at a reasonable price. Advocates here compute a very similar statistic called the PEG ratio, or price-to-earnings ratio divided by the growth rate of earnings. The PEG ratio is essentially the inverse of the ratio that Peter Lynch recommended in his book, assuming you add the dividend yield to the growth rate. The lower the PEG ratio, the more attractively priced a firm is with respect to its projected earnings growth. According to Lynch’s criteria, you would be looking for firms with lower PEG ratios, preferably 0.5 or less, but certainly less than 1.

  But the days of getting those wonderfully low PEG ratios may be gone for good. A look at Table 3.2 shows none of these corporate El Dorados would have qualified as a buy according to Lynch’s rules, and only Philip Morris had a PEG ratio less than 1. Yet all of these firms did extremely well for their shareholders. Their secret: above-average earnings growth for a long period needs only a small growth advantage to do fabulously in the long run. Persistence of good earnings growth is better than transience of superb growth.

  COMMON CHARACTERISTICS OF THE CORPORATE EL DORADOS