The Future for Investors

by Jeremy J Siegel

  But these two sectors experienced very different returns. At 14.19 percent per year, health care had the best return of all ten sectors of the S&P 500 Index, averaging more than three percentage points per year above the S&P 500 Index. But the financial sector, which expanded more than any other sector in the economy, had returns that fell behind the index.

  FINANCIAL

  The financial sector experienced mediocre returns, despite the rapid expansion of its share, because much of its growth has come from the addition of new firms to the index. I noted in Chapter 2 that Standard & Poor’s put a large number of banks in the index in 1976, and this explains the jump in the sector weight in Figure 4.1. Currently the financial sector is now dominated by such giant firms as Citigroup, AIG, Bank of America, Wells Fargo, and J.P. Morgan Chase that were not in the Index in 1957.

  Some of the financial sector’s growth is attributable to the privatization of the government-sponsored enterprises Fannie Mae and Freddie Mac, which were added to the S&P 500 Index in 1988 and 1992. These two firms together accounted for 5 percent of the market value of this sector at the end of 2003.

  Further fueling growth in market share was the addition of brokerage houses and investment banks. Virtually all brokerage firms were private partnerships until 1970, when Donaldson, Lufkin, and Jenrette (DLJ) went public. Later Merrill Lynch, Dean Witter, Schwab, Lehman Brothers, Bear Sterns, T. Rowe Price, and others subsequently went public and were admitted to the S&P 500 Index. Finally, real estate investment trusts, or REITs, were added to the sector in 2001. I shall speak more of REITs and other dividend-rich companies in Chapter 9.

  The tremendous growth in financial products has spurred the growth of many new firms. This has caused a steady increase in the market share of the financial sector, but competition has kept the returns on financial stocks close to average over the whole period.

  HEALTH CARE

  The health care sector, like the financial sector, has steadily increased its share over the past half century. The increase in market value has gone hand in hand with the dramatic increase in health care expenditures. In 1950, 4.5 percent of our GDP was devoted to health care. Today the percentage is 15 percent and growing rapidly.

  Many of the firms that dominate the health care sector today, such as Pfizer, Johnson and Johnson, and Merck, have long and distinguished histories. These firms have been joined by biotechnology firms such as Amgen and Genentech, health care providers such as UnitedHealth and Cardinal Health, and medical equipment companies such as Guidant.

  Although on the whole investors in the health care sector were richly rewarded, they would have done even better without the newcomers. In an industry where research leads to continuous, well-publicized breakthroughs, investor excitement had led to higher prices and disappointing returns.

  Of the eleven health services companies added to the health care sector since 1957, nine of them subsequently underperformed the sector, and some, such as Beverly Enterprises, Community Psychiatric Centers, and HealthSouth, have lagged dramatically. American Hospital Supply, Baxter Travenol (now Baxter International), and Becton Dickinson, three medical equipment providers that were added to the index in 1972, have also underperformed the sector. Bausch & Lomb, added to the S&P 500 in 1986, underperformed the health care sector by 9 percent per year. The tried and true trumped the new in this sector as it did in others.

  The Consumer Sectors: Discretionary and Staples

  Both the consumer staples and consumer discretionary sectors target the consumer, but that is where the similarity between these sectors ends. The firms in the discretionary sector have gone through much turmoil while the staples sector has nurtured the best tried-and-true companies. Staples refers to products described as necessities, whose sales are less prone to economic cycles, and include food, beverages, tobacco, soap, toiletries, and groceries. The consumer discretionary sector, which includes goods and services not viewed as necessities, are purchased relatively infrequently and are more dependent on consumers’ discretionary income. This includes automobiles, restaurants, department stores, and entertainment.

  To some extent, this division is arbitrary—what is one man’s necessity is another’s indulgence. The arbitrariness was illustrated when Standard & Poor’s switched Wal-Mart from the consumer discretionary sector to the consumer staples sector in April 2003 as the retailing giant successfully entered the food market.

  However defined, there has been a world of difference between the performance of firms in these two sectors. The consumer staples sector has been marked by unusual stability. Most of the largest firms in this sector (excepting the recent addition of Wal-Mart) have been around for fifty years or more and provided investors with superb returns. We have already noted the superior long-term performance of such companies as Coca-Cola, Philip Morris, Procter & Gamble, PepsiCo, and others. Twelve of the top twenty surviving stocks of the original S&P 500 firms came from the consumer staples sector.

  In contrast, the consumer discretionary sector has been marked by tumult. The sector was once dominated by the auto manufacturers (GM, Chrysler, and then Ford), their suppliers (Firestone and Goodyear), and large retailers (Sears, J.C. Penney, and Woolworth). All these companies fared very poorly.

  The old-line retailers were pushed aside by Wal-Mart and Home Depot, and the auto manufacturers were shellacked by foreign imports and high labor costs. Today, four out of the five largest firms in the sector are in entertainment: Time Warner, Comcast, Viacom, and Disney. It is amazing that one has to go down to the eleventh largest firm in the current S&P consumer discretionary sector to find a firm (Ford Motor) that was a member of the original S&P 500 Index.

  The consumer discretionary sector is the only one of the ten sectors where the original firms in the S&P 500 Index did not outperform the new ones that were added. The dreadful performance of GM, an original S&P 500 firm, and the superior performance of newcomer Wal-Mart is the prime reason for this difference.

  The fate of the autos and retailers in the consumer discretionary sector and the rise of Home Depot, Wal-Mart, and the new entertainment companies is consistent with the creative destruction theory of stock selection: old, dying companies eclipsed by young, vigorous firms. What is noteworthy is that this is the only sector where the principle of creative destruction actually worked for investors, as the new firms did outperform the old.

  Two questions come to mind: why did the discretionary sector experience so much upheaval, and why did the returns of the consumer staples sector far outstrip returns of the consumer discretionary sector?

  This was a most unexpected outcome on the basis of economic trends. Over the past half century, one would have never expected the staples sector to outperform the discretionary sector. The last fifty years have witnessed a dramatic rise in discretionary income (after which the sector is named), as prosperity enabled millions of Americans to expand their purchases beyond basic necessities.

  But the discretionary sector did not prosper. The firms in this sector were unable to maintain quality and foster consumer loyalty. And they ignored the growing threat of foreign competition, particularly from the Japanese, whose emphasis on quality quickly won over consumers.

  In contrast, firms in the staples sector marketed their products internationally, maintaining and capitalizing on their reputation for high quality. They fully understood that trust and reliability were their most sought-after products and rewarded investors accordingly. In Chapter 17 I shall explain why I think the consumer staples sector will continue to give investors superior returns.

  INDUSTRIAL SECTOR

  The industrial sector includes industrial conglomerates, transportation, and defense firms. The heavyweight in this sector, General Electric, was the largest firm in the industrial sector when the S&P 500 Index was founded, and it remains so today.

  But GE’s dominating size is about the only aspect of this sector that remains unchanged. Although 3M (formerly Minnesota Mining and Manufacturing), Unite
d Technologies (formerly United Aircraft), and Boeing were members of the original S&P 500 Index, none of the five airlines (American, Eastern, United, Pan Am, and TWA) that was in the 1957 index is still there today.5

  As of this writing, General Electric had the highest market capitalization of any firm in the United States. Its legendry former chairman, Jack Welch, took over the reins of the company in 1981 and transformed GE into one of the most dynamic and well-respected companies in the world. The “GE Way,” promoted by Welch, demanded excellence in every business the firm entered and has contributed much to the company’s success. Welch’s strategy concentrated on the core competencies of the firm; if a division was not profitable, GE sold it.

  Although General Electric has recently moved into the entertainment industry (with NBC and now Universal), its prize division is financial, which includes consumer and commercial financing as well as insurance, and provides almost half of the company’s revenues and profits. GE Capital, would be, if divested from the parent, one of the largest financial institutions in the world.

  The iconic status of GE and Jack Welch encouraged investors to push the price of GE stock to unsustainable levels during the great bull market of the 1990s. In 2000, GE reached a price-to-earnings ratio of 50—an unheard-of and, unfortunately, unsustainable level for an industrial firm.

  GE’s stock price subsequently declined by two-thirds, and its return from 1957 has since been eclipsed by 3M, one of the few industrial firms that has not been buffeted by the economic, financial, and legal storms that have rocked such companies as Boeing, Honeywell, Caterpillar, and more recently Tyco.

  The railroad firms in this sector shrunk dramatically in size relative to the rest of the market, declining from 21 percent of the market value of the industrial sector to less than 5 percent today. The railroad industry is a good illustration of how creative destruction gets turned on its head when applied to investors. The industry was already in decline in the mid-1950s when it was hit with a one-two punch. First, the completion of the interstate highway system created severe competition from the trucking industry and reduced rail passenger travel. Many railroads, such as Penn Central, Reading, and Erie Lackawanna, were forced into bankruptcy. Second, the airlines took almost all long-haul passengers away from the railroads.

  Nevertheless, since 1957 railroad stocks have surprisingly outperformed not only the airlines and trucking industries but even the S&P 500 Index itself.

  How did this happen? How could the lowly railroad industry outperform one of the world’s hardest to beat market indexes? Again, it’s all about expectations. The bankruptcies and other problems the rail companies faced dramatically lowered investor expectations. Only a small improvement was necessary for these companies to subsequently beat this dim outlook.

  And better times were coming. In 1980 there was a major deregulation of the railroads that spurred consolidation and greatly increased their efficiency. Despite falling revenues, rail productivity has tripled since 1980, generating healthy profits for the carriers. Burlington Northern Santa Fe, the star performer of the four major surviving railroads, has achieved an astounding 17 percent annual return since 1980, more than 4 percentage points higher than the S&P 500 Index.

  The railways offer an important lesson for investors: an industry that has been in a long decline can provide stockholders with excellent returns. This is because investor expectations are so low. If the firm halts its decline and becomes profitable—particularly if management can pay dividends—then these shares can provide excellent forward-looking returns. Who would have thought thirty years ago that investors would do so well in the dying railroad industry and do so badly with soaring airlines?

  MATERIALS SECTOR

  The materials sector consists of manufacturing firms producing basic commodities, such as chemicals, steel, and paper. This sector has experienced the greatest erosion in market share and the lowest returns.

  In 1957, when the S&P 500 Index was formulated, materials was the largest sector in the index, responsible for over 25 percent of the market value of all S&P 500 firms. Chemical and steel companies led this sector, which included such behemoths as United States Steel and Bethlehem Steel and large chemical companies such as DuPont, Union Carbide, and Dow Chemical. These five firms dominated the U.S. industrial landscape in the late nineteenth century and the first half of the twentieth century and were 10 percent of the S&P 500’s market value when the index was formulated.

  But in the last fifty years, these great firms witnessed a rapid decline, and the materials sector’s share fell by almost 90 percent. The combined market valuation of those five big steel and chemical firms declined to less than 1 percent of the index today.

  The decline can be traced to international competition and the economic shift from manufacturing to services. Through the 1970s and 1980s production from Japan and then the rest of Asia made these industries vulnerable to lower-cost producers. These old-line manufacturing firms, saddled with high labor costs and crushing pension benefits that were negotiated when profits were high, have seen their shares decimated. Some, such as Dow Chemical, the best performer of the lot, were almost brought down by litigation, in Dow’s case over silicone implants.

  THE TELECOMMUNICATIONS SECTOR

  The telecommunications sector, which includes AT&T, once the world’s largest firm, has seen its share of the index cut in half, falling from 7.5 to 3.5 percent over the past half century. Telecom experienced a brief surge in the late 1990s when it soared to over 11 percent of the index as the excitement of the Internet fueled expectations of vastly increased profits. But oversupply, plunging prices, and expanding debt incurred to build huge fiber-optic networks caused telecom stocks to collapse.

  The telecommunications industry sadly illustrates how rapid productivity growth can be devastating to both firms and investors; its story will be featured in Chapter 8. This industry, which laid the foundation for the productivity revolution that will sweep the world in the coming decades, is a prime example of how firms operating at the forefront of Schumpeter’s creative destruction process can themselves be destroyed by their own inventiveness.

  Like energy in the 1980s and tech in the late 1990s, telecommunications demonstrates how outsized expectations during a boom increase the number of firms in the sector and how these new firms subsequently underperform. The telecom sector added virtually no new firms from 1957 through the early 1990s. But in the late 1990s, new firms, such as WorldCom, Global Crossing, and Qwest Communications, entered the index with great fanfare, only to collapse afterward.

  In June 1999 WorldCom constituted over 16 percent of the telecom sector’s market value, but the firm subsequently lost 97.9 percent of its value by the time it was deleted from the index in May 2002. Global Crossing fell more than 98 percent before it was deleted from the index in October 2001, and Qwest lost over 90 percent of its value since its admission in July 2000. These overpriced new firms significantly underperformed the original firms in the telecom sector.

  THE UTILITY SECTOR

  The utility sector also experienced a sharply declining market share. One source of the decline is the fall in the real price of energy as the generation and consumption of electricity became more efficient.6 The U.S. economy can produce almost twice as much GDP per unit of fossil fuel now as it did in the early 1970s.

  But a more important source of utilities’ troubles was the deregulation of the energy industry, which has removed these firms from the protected monopolist status that they enjoyed during most of their history. Until the mid-1980s regulators would routinely allow utilities to pass on any increase in costs directly to the consumers, who had no choice but to buy energy from these monopoly producers and distributors. But consumers balked at accepting the mammoth cost overruns of nuclear power generation, and when communities were able to obtain cheaper power from more distant sources, utility profits plummeted. Only recently have some of these firms begun to learn to deal with a deregulated environmen
t, raising hopes for better returns.

  Utility firms do have high dividend yields, which, as I noted, is an important factor in generating good long-term returns. However, there is not enough history to be certain how these firms will continue to perform in a deregulated environment.

  Sector Shifts and Sector Returns

  The returns of these ten great sectors tell an important story. In Chapter 2 I explained why market value does not necessarily correlate with investor returns. This chapter shows that it holds true for the returns to market sectors as well as individual firms. Figure 4.3 summarizes the data. It plots the return on each sector in the S&P 500 Index against the change in the sector’s weight over the entire period from 1957 through 2003.

  Both the financial and health care sectors experienced strong growth. The health care sector delivered, by a wide margin, the highest returns of all the sectors, but the financial sector had below-average returns. The reason is that the growth in market capitalization of the financial sector was mostly fueled by the entrance of new firms, a factor far less important in the health care sector.

  Information technology had the second highest gain in market share but only slightly above-average returns. The single reason why the sector outperformed the S&P 500 Index was IBM’s performance from 1957 to 1962. On average, the other technology firms gave investors below-average returns despite their critical importance to the economy.