The characteristics of these winning firms have become clear. The corporate El Dorados had earnings growth expectations that were only slightly above the market average, but they delivered considerably faster earnings growth, especially when viewed over a forty-six-year period. None of these firms had an average P/E ratio above 27, and virtually all paid consistent and rising dividends, with a dividend yield near the market average. Because of their higher-than-expected earnings growth, the reinvestment of dividends at undervalued prices magnified the returns of these companies, just as it did for Philip Morris.
The overwhelming number of these firms have developed high-quality, branded consumer products that have been marketed successfully not only in the United States but around the world. Trust in the product quality is of paramount importance to their success, allowing the firms to charge a higher price than the competition and attain higher profit margins.
Charlie Munger, Warren Buffett’s long-time partner at Berkshire Hathaway, hit the nail on the head when he described why some companies are able to charge higher prices:
If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So if one is 40 cents and the other is 30 cents, am I going to take something I don’t know and put it in my mouth, which is a pretty personal place after all, for a lousy dime?9
Those “lousy dimes,” summed over billions of dollars of sales, can add up to a pretty penny.
Corporate El Dorados of the Past: The Nifty Fifty of the 1970s
This is not the first time I noticed these corporate El Dorados. In the early 1990s I did a study of a set of stocks that gained notoriety in the early 1970s and were referred to as the “Nifty Fifty.”10 These were a group of premier stocks, such as Philip Morris, Pfizer, Bristol-Myers, PepsiCo, Coca-Cola, General Electric, Merck, Heublein, Gillettte, Xerox, IBM, Polaroid, and Digital Equipment, that had excellent growth records over the past decade and had become widely sought by institutional investors. Some analysts called these firms “one-decision stocks,” as they urged investors to buy but never sell.
These stocks hit a peak in December 1972, when their average P/E ratio exceeded a then unheard-of 40. They were crushed in the 1973–74 bear market and held up as examples of unwarranted optimism about the ability of growth stocks to continue to generate rapid and sustained earnings growth. Yet buy-and-hold proved to be a good decision for many of these stocks—as long as you were careful not to buy those with the highest growth expectations and prices.
The twenty-five Nifty Fifty stocks with the highest P/E ratios, which in 1972 averaged a stunning 54, returned more than three percentage points less than the twenty-five stocks with the lowest P/E ratios, which averaged a more reasonable 30. Johnson & Johnson was the only stock with a P/E above 50 in the original Nifty Fifty that subsequently outperformed the S&P 500 Index, and Polaroid, the stock with the highest P/E ratio and highest expectations, delivered the absolute worst returns.
It is remarkable that not a single technology or telecommunication stock in the Nifty Fifty performed well for investors: not IBM, Digital Equipment, Xerox, Burroughs, or ITT. All of these technology firms lagged the market, some by very wide margins. There is also no technology or telecommunication stock on any of the top-twenty lists that we generated in this chapter. This is because investors generally expect the technology firms to have very strong earnings growth, so even when these firms do prosper, these optimistic expectations were already built into their prices.
Peter Lynch summed up the seductive allure and empty promises made by the technology companies well in his 1993 best-seller Beating the Street,
Finally, I note with no particular surprise that my most consistent losers were the technology stocks, including the $25 million I dropped on Digital in 1988, plus slightly lesser amounts on Tandem, Motorola, Texas Instruments, EMC (a computer peripherals supplier), National Semiconductor, Micron Technology, Unisys, and of course that perennial dud in all respectable portfolios, IBM. I never had much of a flair for technology, but that didn’t stop me from occasionally being taken in by it.11
Lessons for Investors
This research suggests that investors should be willing to pay twenty or thirty times earnings for these corporate El Dorados. But don’t be dazzled by newcomers whose long-term prospects are yet to be tested. The research of the past half century showed that the tried and true clearly triumphed over the bold and new.
What are the most important lessons that can be taken from this chapter?
• The best-performing firms for investors have been those with strong brand names in the consumer staples and pharmaceutical industries. As Warren Buffett rightly claimed, “The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”12 The familiar brand-name firms that have achieved such superior returns for their shareholders are what I call the triumph of the tried and true.
• The basic principle of investor return states that stockholder returns are driven by the difference between actual and expected earnings growth, and the impact of this difference is magnified by dividends.
• The majority of best-performing firms have had (1) slightly higher-than-average P/E ratios, (2) average dividend yields, but (3) much higher-than-average long-term earnings growth. None of the best-performing stocks had an average P/E over 27. These are the characteristics of the corporate El Dorados.
• No technology or telecommunications firm made the list of best-performing stocks.
• Portfolios invested in the lowest-P/E stocks—in other words, those with modest expectations for growth—far outperformed those with higher valuations and expectations.
• Be ready to pay up for good stocks (as you would for good wine), but there is no such thing as a “buy at any price.”
Now that I have specified the principles of choosing superior individual stocks, I will shift to one of the hottest trends in the investment business: investment by industry or sector. In the next chapter I will explore how sector investing impacts your portfolio.
CHAPTER FOUR
Growth Is Not Return:
THE TRAP OF INVESTING IN HIGH-GROWTH SECTORS
Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
—Benjamin Graham, The Intelligent Investor, 1973
Sector-based investment strategies that are based on industries rather than geographical location or valuation are rapidly gaining popularity.
In June 2004, Morgan Stanley’s quantitative analytics team concluded that there was “no basis for the traditional methodology of global asset allocation, namely ‘regional first, then sector.’ ” Instead, Morgan Stanley believes investors ought to focus their asset allocation strategies more prominently on industry groups.1 Industry-based strategies are becoming so important that global investment banking firm Goldman Sachs recently created a new equity research group that focuses only on sector strategies.2
Investors frequently ask me, “What are the next fast-growing industries that I should invest in?” There is the near-universal belief that the fastest-growing industries will yield the best returns.
But the reality differs from this perception.
Of the ten major industries, the financial sector has gained the largest share of market value since the S&P 500 Index was founded in 1957. Financial firms went from less than 1 percent of the index to over 20 percent in 2003, while the energy sector has shrunk from over 21 percent to less than 6 percent over the same period. Had you been looking for the fastest-growing sector, you would have sunk your money in financial stocks and sold your oil stocks.
But if you did so, you would have fallen into the growth trap. Since 1957, the returns on financial stocks have actually fallen behind the S&P 500 Index, while energy stocks have outperformed over the same period. For the long-term investor, the strategy o
f seeking out the fastest-growing sector is misguided.
What is going on here is identical to what we have already learned: growth in market value and investor returns, especially in the long run, can move in very different directions. This chapter shows that the same holds true for entire industries as well as individual firms.
The Global Industrial Classification Standard (GICS)
Our current sector classification system was reformulated in 1999 when Standard & Poor’s joined Morgan Stanley to create the Global Industrial Classification Standard, or GICS. This system arose from earlier classification standards, devised by the U.S. government, that had grown less suited to our service-based economy.3 GICS breaks the U.S. and world economy down into ten sectors: materials, industrials, energy, utilities, telecommunication services, consumer discretionary, consumer staples, health care, financial, and information technology.
We have gone back and classified each of the original S&P 500 firms and their successors into the current GICS system. Table 4.1 summarizes the returns of these sectors as well as the change in market share of each industry since the S&P 500 was first formulated in 1957.
You can see that there is no strong correspondence between the expansion or shrinkage of the sector and the returns to investors. The two sectors that expanded the most, financial and information technology, experienced only mediocre returns. Furthermore, the original 1957 firms in each sector except one outperformed the new firms that were added to that sector.
These data confirm my basic thesis: the underperformance of new firms is not confined to one industry, such as technology, but extends to the entire market. New firms are overvalued by investors in virtually every sector of the market.
The change in market share of some of the sectors has been dramatic. The materials and energy sectors, which in 1957 were the largest sectors, have by 2003 become among the smallest sectors, making up less than 10 percent of the index. In contrast, the three smallest sectors in 1957, the financial, health care, and technology sectors, today account for more than half of the market value of the index.
TABLE 4.1: MARKET SHARE AND RETURNS, 1957–2003
Figure 4.1 shows the change in market weights over time. One can see the jump in financial market share in 1976 when, as noted in Chapter 2, Standard and Poor’s added twenty-five banks and insurance companies to the index. The surges in the energy share in the late 1970s and the technology share in the late 1990s are also visible.
It is important to remember that the rising or falling market weights are not the same as rising or falling investor returns, especially in the long run. As noted earlier, even though the financial and technology sectors show pronounced market value expansion over the past half century, their returns were no better than average.
In the rest of the chapter, I will go through each of the ten sectors, describing its transformation, why new firms underperformed the older firms, and what this means for investors.
FIGURE 4.1
Bubble Sectors: Oil and Technology
Figure 4.2 shows how the share of the market value of the energy and technology sectors has changed from 1957 through 2003. What jumps out is that both sectors experienced sharp surges in market value that quickly subsided.
These spikes—or bubbles, as I will call them—are strikingly similar and separated by almost exactly twenty years. The oil sector was driven by fear in the late 1970s that the world would soon run out of oil and the price of oil stocks, especially those connected with oil and gas exploration, surged. In the technology sector, a rush of spending on Y2K and excitement about the Internet sent technology stocks sharply higher in the late 1990s. Both of these sectors hit their peak at just over 30 percent of the total value of the S&P 500.
The behavior of energy and technology suggests that investors should sell if a sector becomes this large. But that is not necessarily the case. There is a difference between sectors whose weights are rising on a long-term basis, such as financial or health care, and those, like energy and technology, that suddenly surge to a higher level. It is the latter that should worry investors.
FIGURE 4.2: THE ENERGY AND INFORMATION TECHNOLOGY BUBBLES
One clear indication of a bubble is the rapidity of the price rise. Although there are occasions when sharp increases in the price of individual stocks are justified, this has never been true of market sectors. Fundamentals do not change rapidly enough to justify the sudden increase in the market share of major sectors, such as oil and technology experienced. The causes of the oil and technology bubbles will be described in great detail in Part 2.
While both the energy and technology sectors experienced bubbles, their market shares have been moving in opposite directions—technology upward and energy downward.
Nevertheless, investors would have far preferred to link their fortunes to the falling share of energy stocks rather than to the rising share of technology stocks. The return on the original firms of the shrinking energy sector far surpassed that of the expanding tech sector, just as the return on Standard Oil of New Jersey surpassed that of IBM. The fast-paced technology sector, clearly responsible for much of our economic growth, could not keep up with the slow-growing but high-returning oil companies.
ENERGY
Why did the energy sector perform so well? The oil firms concentrated on what they did best: extracting oil at the cheapest possible price and returning profits to the shareholders in the form of dividends. Furthermore investors had low expectations for the growth of energy firms, so these stocks were priced modestly. The low valuations combined with high dividends contributed to superior investor returns.
Nevertheless, even in the shrinking energy sector, the growth trap ensnared many investors. The sharp rise in energy prices during the 1970s caused investors to rush to buy many new oil and gas exploration firms, sending their price upward.
In August 1980, right at the peak of the oil bubble, Standard & Poor’s put out an oil industry survey entitled “Shares Have Long-term Appeal,” in which they predicted that profits would continue to grow. They singled out five firms, Baker International, Global Marine, Hughes Tool, Schlumberger, and Western Co. of North America, noting:
These very favorable incentives [high oil prices] have not been lost to the investor, and most of the stocks in the oil well equipment and services and offshore drilling sectors are selling at hefty P-E premiums to the general market. But it is hard to argue with the favorable prospects for the group, and we recommend the issues on a long-range basis.4
Unfortunately, these analysts violated a fundamental rule of investing: never buy stocks, especially large-cap stocks, selling at “hefty P-E premiums to the general market,” particularly for the long run. These oil services and oil exploration stocks flamed out in the 1982 worldwide recession. Oil prices plummeted, and drilling activity abruptly came to a halt. Global Marine and Western Co. of North America went bankrupt, and the other three firms seriously underperformed the market. In fact, twelve of the thirteen energy stocks that were added to the S&P 500 during the late 1970s and early 1980s did not subsequently match the performance of either the energy sector or the S&P 500 Index.
TECHNOLOGY
Many investors assume that firms that have developed path-breaking technologies rank among the best long-term investments. But the spectacular gains in Microsoft, Cisco, Intel, Dell, and others are overshadowed by the dreadful losses in innovative firms such as Digital Equipment (minicomputers), Sperry Rand (Univac, first computer), Xerox (first copier), and Burroughs (first electronic calculating machines). As a result, the technology sector barely managed to match the S&P 500 Index and would have dropped below the index if not for the superior performance of IBM from 1957 through the early 1960s when it monopolized the computer market.
The technology companies consistently commanded high valuations. In the early 1960s the tech sector, fueled by expectations of rapid growth of computers, sported a P/E ratio of 56, more than two and a half times that of the market. Fro
m 1957 through 2003, the average P/E of the technology sector was 26, a full ten points higher than the overall market. There was only one stretch in the last forty-five years when expectations for earnings growth in the technology sector were below that for the overall market, and that was in the early 1990s, after three consecutive years of large losses by IBM. Although many technology firms experienced rapid earnings growth, investors typically had even higher growth expectations built into share prices, resulting in poor investment returns.
About 30 percent of the 125 firms that have been added to the technology sector of the S&P 500 since 1957 were done so in 1999 and 2000. Those added in 1999 subsequently underperformed the technology sector by 4 percent per year, while those admitted in 2000 underperformed by a whopping 12 percent per year. Furthermore the technology sector itself greatly underperformed the market from 1999 onward. Many newly added S&P technology stocks, such as Broadvision, Vitesse Semiconductor, Palm, and JDS Uniphase, fell by 95 percent or more.
Despite their similarities, the energy and technology bubbles displayed some important differences. In the technology bubble, the P/E ratios rocketed to extreme levels because of overly optimistic expectations of future earnings growth. In the oil sector, valuations never reached such extreme levels because the price of oil stocks rose along with earnings. In fact, the large integrated oil producers that dominated the sector sold at lower P/E ratios than the rest of the market at the peak of the bubble. The oil bubble centered on the oil drillers and explorers that sold at large premiums to the market.
Financial and Health Care: Expanding Industries
Health care and financial are the two sectors with the most pronounced expansion in market share. In 1957 they were the two smallest sectors, responsible for a total of 1.9 percent of the market value. By the end of 2003, they were the largest sectors, together accounting for 34 percent of the value of the S&P 500 Index.
The Future for Investors Page 6
