The Future for Investors

by Jeremy J Siegel

  ALSO BY JEREMY J. SIEGEL

  Stocks for the Long Run

  Copyright © 2005 by Jeremy J. Siegel

  All rights reserved.

  Published in the United States by Crown Business,

  an imprint of the Crown Publishing Group,

  a division of Random House, Inc., New York.

  www.crownpublishing.com

  CROWN BUSINESS is a trademark and the Rising Sun colophon

  is a registered trademark of Random House, Inc.

  Library of Congress Cataloging-in-Publication Data

  Siegel, Jeremy J.

  The future for investors: why the tried and the true triumph

  over the bold and the new / Jeremy J. Siegel.—1st ed.

  1. Stocks. 2. Stocks—History. 3. Rate of return.

  4. Stocks—Rate of return. I. Title.

  HG4661.S52 2005

  332.63′22—dc22 2004022938

  eISBN: 978-0-307-23664-7

  v3.1

  To Paul Samuelson, my teacher, and

  Milton Friedman, my mentor, colleague, and friend.

  CONTENTS

  Cover

  Other Books by This Author

  Title Page

  Copyright

  Dedication

  Preface

  PART ONE: UNCOVERING THE GROWTH TRAP One: The Growth Trap

  Two: Creative Destruction or Destruction of the Creative?

  Three: The Tried and True:

  Finding Corporate El Dorados

  Four: Growth Is Not Return:

  The Trap of Investing in High-Growth Sectors

  PART TWO: OVERVALUING THE VERY NEW Five: The Bubble Trap:

  How to Spot and Avoid Market Euphoria

  Six: Investing in the Newest of the New:

  Initial Public Offerings

  Seven: Capital Pigs:

  Technology as Productivity Creator and Value Destroyer

  Eight: Productivity and Profits:

  Winning Managements in Losing Industries

  PART THREE: SOURCES OF SHAREHOLDER VALUE Nine: Show Me the Money:

  Dividends, Stock Returns, and Corporate Governance

  Ten: Reinvested Dividends:

  The Bear Market Protector and Return Accelerator

  Eleven: Earnings:

  The Basic Source of Shareholder Returns

  PART FOUR: THE AGING CRISIS AND THE COMING SHIFT IN GLOBAL ECONOMIC POWER Twelve: Is the Past Prologue?

  The Past and Future Case for Stocks

  Thirteen: The Future That Cannot Be Changed:

  The Coming Age Wave

  Fourteen: Conquering the Age Wave:

  Which Policies Will Work and Which Won’t

  Fifteen: The Global Solution:

  The True New Economy

  PART FIVE: PORTFOLIO STRATEGIES Sixteen: Global Markets and the World Portfolio

  Seventeen: Strategies for the Future:

  The D-I-V Directives

  Appendix: The Complete Corporate History and

  Returns of the Original S&P 500 Firms

  Notes

  Acknowledgments

  About the Author

  PREFACE

  My first book, Stocks for the Long Run, was published in 1994 when the U.S. market was midway through its longest and strongest bull market in history. My research showed that over extended periods of time, stock returns not only dominate the returns on fixed-income assets, but they do so with lower risk when inflation is taken into account. These findings established that stocks should be the cornerstone of all long-term investors’ portfolios.

  The book’s popularity led to many speaking engagements before audiences of individual and professional investors. After my presentations, two questions invariably came up: “Which stocks should I hold for the long run?” and “What will happen to my portfolio when the baby boomers retire and begin liquidating their portfolios?”

  I wrote The Future for Investors to answer these questions.

  The Great Bull Market of the 1990s

  In Stocks for the Long Run, I recommended that investors link the equity portion of their portfolio to broad-based indexes of stocks, such as the S&P 500 Index or the Wilshire 5000. I had seen so many investors succumb to the temptation of trying to “time” the ups and downs of the market cycle that I believed a simple, disciplined, indexed approach was the best strategy. I did discuss some techniques that might improve on these indexed returns, but these suggestions were never central to the major thesis of the book.

  Although indexation was a very good strategy for investors in the 1990s, by the end of the decade I became increasingly uncomfortable with the valuations that were put on many stocks. I thought frequently of what Paul Samuelson, my graduate school mentor and first American Nobel prize winner in economics, wrote on the cover of Stocks for the Long Run:

  Jeremy Siegel makes a persuasive case for a long-run, buy-and-hold investment strategy. Read it. Profit from it. And when short-run storms rock your ship, sleep well from a rational conviction that you have done the prudent thing. And if you are a practitioner of economic science like me, ponder as to when this new philosophy of prudence will self-destruct after Siegel’s readers come some day to be universally imitated.

  When he wrote this in 1993, stock valuations were near their historical averages, and there was little danger that the market would “self-destruct.” But as the Dow Industrials crossed 10,000, and Nasdaq approached 5,000, stock prices relative to either earnings or dividends climbed to higher levels than they had ever reached before. I worried that stock prices had reached heights from which they would yield poor returns. It was tempting to urge investors to sell and wait for prices to come back down before going back into stocks.

  But when I investigated the market in depth, I found that overvaluation infected only one sector—technology; the rest of the stocks were not unreasonably priced relative to their earnings. In April of 1999, I took a stand on the pricing of Internet stocks by publishing an op-ed piece in the Wall Street Journal entitled “Are Internet Stocks Overpriced? Are They Ever!” It was my first public warning about market valuations.

  Shortly before that article appeared, I invited Warren Buffett to speak before the Wharton community. He had not been on campus since he left the Wharton undergraduate program in 1949. He spoke to an overflowing crowd of more than one thousand students, many of whom had waited hours in line to get an opportunity to hear his wisdom on stocks, the economy, and whatever else was on his mind.

  I introduced Warren to the audience and detailed his extraordinary investment record. I was particularly honored when, in response to a question about Internet stocks, he urged the audience to read my Journal piece that had been published just a few days earlier.

  His encouragement persuaded me to look deeper into the technology stocks that were selling at unprecedented valuations. At that time, technology stocks were all the rage and not only had the market value of the technology sector reached almost one third of the entire S&P 500’s market value, but trading volume on Nasdaq for the first time in history eclipsed that on the New York Stock Exchange. I penned another article for the Journal in March 2000 entitled “Big Cap Tech Stocks Are a Sucker’s Bet.” I argued that stocks such as Cisco, AOL, Sun Microsystems, JDS Uniphase, Nortel, and others could not sustain their high prices and were heading for a severe decline.

  If investors had avoided technology stocks during the bubble, their portfolios would have held up very well during the bear market. Indeed, the cumulative return of the 422 stocks in the S&P 500 Index that are not in the technology sector is higher than it was at the market peak in March 2000.

  Long-term Performance of Individual Stocks

  My interest in the
long-term returns of individual stocks was piqued by the experience of one of my close friends, whose father had purchased AT&T fifty years earlier, reinvested the dividends, and held all the firms spun-off from Ma Bell. A modest initial investment had turned into a substantial bequest.

  Similarly, much of Warren Buffett’s success was also attributable to holding good stocks over long periods of time. Buffett has remarked that his favorite holding period is forever. I was curious how investors’ portfolios would have performed if they did just that—bought a group of large capitalization stocks and held on to them for many decades.

  Computing long-term, “buy-and-hold forever” returns seems like it would be an easy task. But the reality proved otherwise. The returns data on individual stocks available to academics and professionals assumed that all stock distributions and spin-offs were immediately sold and the proceeds reinvested in the parent firm. But this assumption did not match the behavior of many investors, such as my friend’s father who purchased AT&T around 1950.

  I went back a half century and investigated the long-term returns of the twenty largest stocks trading on the New York Stock Exchange, assuming dividends were reinvested and all distributions were held. To reconstruct these buy-and-hold returns was a time-consuming but ultimately extremely rewarding endeavor. To my amazement, the performance of the “Top Twenty,” as I called this group of stocks, beat the returns of an investor who indexed to the entire market, which included all the new firms and new industries.

  After that preliminary investigation, I was determined to explore the returns on all the 500 firms that constituted the S&P 500 Index when it was first formulated in 1957. This project yielded the same surprising conclusion—the original firms outperformed the newcomers.

  These results confirmed my feeling that investors overprice new stocks, many of which are in high technology industries, and ignore firms in less exciting industries that often provide investors superior returns. I coined the term “the growth trap” to describe the incorrect belief that the companies that lead in technological innovation and spearhead economic growth bring investors superior returns.

  The more I investigated returns, the more I determined that the growth trap affected not just individual stocks, but also entire sectors of the market and even countries. The fastest-growing new firms, industries, and even foreign countries often suffered the worst return. I formulated the basic principle of investor return, which specifies that growth alone does not yield good returns, but only growth in excess of the often overly optimistic estimates that investors have built into the price of stock. It was clear that the growth trap was one of the most important barriers between investors and investment success.

  The Coming Age Wave

  Understanding which stocks did well over the last half century helped me address the first of the two questions that I was frequently asked. To address the other, it was necessary to examine the economic consequences of our rapidly aging population. Having been born in 1945, I long realized that I was at the leading edge of the surge of baby boomers that would soon become a tidal wave of retirees.

  Investor interest in the impact of the population trends on stock prices was sparked by Harry Dent, whose 1993 best-seller, The Great Boom Ahead, provided a novel explanation of historical stock trends. Dent found that stock prices over the last century correlated well with the population between forty-five and fifty years of age, an age that corresponded to peak consumer spending. On the basis of population projections, Dent predicted that the great bull market would extend to 2010 before crashing when the boomers entered retirement.

  Harry Dent and I were invited to speak at many of the same conferences and conventions, although we rarely shared the same platform. I had never before used population trends to predict stock prices, preferring to use historical returns as the best estimate of future returns.

  But the more I looked into demographics, the more I believed that population trends were critical to our economy and to investors. Although the United States, Europe, and Japan are getting older, most of the world is very young and these young economies are finally making their presence felt. Thanks to the superb technical ability of Wharton students, I was able to construct a model that integrated international demographic and productivity trends to forecast the future of the world economy.

  The results were exciting and quite different from what Dent was forecasting. Rapid economic growth of the developing countries, if sustained, will have a significantly positive impact on the aging economies, mitigating the negative consequences of the age wave.

  The more I studied the sources of growth, the more I believed that this growth can be sustained due to the communications revolution that enabled vast amounts of knowledge to become available to billions of people worldwide. For the first time, information that in the past could only be accessed at the great research centers of the world suddenly became accessible to anyone with an Internet connection.

  The expansion of knowledge abroad had far-reaching consequences. As an academic, I had seen a dramatic increase in the number of talented students from outside the United States. In fact, the number of international students in our Ph.D. programs now clearly outnumbered the Americans. It was clear that in not too many years the West would no longer have a monopoly on knowledge and research. The diffusion of information around the globe had significant implications for investors everywhere.

  New Approach to Investing

  All these studies had a great impact on my approach to investing. I am often asked whether the bubble and subsequent collapse in the equity market over the past few years have caused me to shift my view of stocks. The answer is yes, it has, but in such a way that makes me just as optimistic about the future for investors.

  Irrational fluctuations in the market, instead of being a source of alarm, give investors the opportunity to do even better than the buy-and-hold returns available on indexed securities. And world economic growth will open new opportunities and new markets to globally oriented firms on an unprecedented scale.

  I believe that to take full advantage of these developments, investors must expand the scope of their portfolios and avoid the common pitfalls that cause the returns of so many to lag the market. It is my goal to provide such guidance in The Future for Investors.

  PART ONE

  Uncovering the Growth Trap

  CHAPTER ONE

  The Growth Trap

  The speculative public is incorrigible. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with “franchising,” computers, electronics, science, technology, or what have you when the particular fashion is raging. Our readers, sensible investors all, are of course above such foolishness.

  —Benjamin Graham, The Intelligent Investor, 1973

  The future for investors is bright. Our world today stands at the brink of the greatest burst of invention, discovery, and economic growth ever known. The pessimists, who proclaim that the retiring baby boomers will bankrupt Social Security, upend our private pension systems, and crash the financial markets, are wrong.

  Fundamental demographic and economic forces are rapidly shifting the center of our global economy eastward. Soon the United States, Europe, and Japan will no longer hold center stage. By the middle of this century, the combined economies of China and India will be larger than the developed world’s.

  How should you position your portfolio to take advantage of the dramatic changes and opportunities that will appear in the world markets?

  To succeed in this rapidly changing environment, investors must grasp a very important and counterintuitive aspect of growth that I call the growth trap.

  The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth—through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries—dooms investors t
o poor returns. In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.

  Ironically, the faster the world changes, the more important it is for investors to heed the lessons of the past. Investors who are alert to the growth trap and learn the principles of successful investing revealed in this book will prosper during the unprecedented changes that will transform the world economy.

  The Fruits of Technology

  No one can deny the importance of technology. Its development has been the single greatest force in world history. Early advances in agriculture, metallurgy, and transportation spurred the growth of population and the formation of great empires. Throughout history, those who possessed technological superiority, such as steel, warships, gunpowder, airpower, and most recently nuclear weapons, have won the decisive battles that allowed them to rule over vast parts of the earth—or to stop others from doing so.

  In time, the impact of technology spread far beyond the military sphere. Technology has allowed economies to produce more with less: more cloth with fewer weavers, more castings with fewer machines, and more food with less land. Technology was at the heart of the Industrial Revolution; it launched the world on a path of sustained productivity growth.

  Today, the evidence of that growth is seen everywhere. In the developed world, only a small fraction of work is devoted to securing life’s necessities. Advancing productivity has allowed us to achieve better health, retire earlier, live longer, and enjoy vastly more leisure time. Even in the poorer regions of our globe, advances in technology during the past century have reduced the percentage of the world’s population faced with starvation and those living in extreme poverty.