The Future for Investors Read online

  The information and communications revolution has enabled the developing nations of the world, such as China and India, to rapidly increase their economic growth, and they are on target to produce more than enough goods and services for the aging population of the developed world. I predict that by the middle of this century, China and India combined will produce more output than the United States, Europe, and Japan put together.

  The two most critical questions facing the developed world are: who will produce the goods that we need and who will buy the assets that we sell? I have found the answer to both questions: the goods will be produced and the assets will be bought by the workers and investors of the developing world. I call this the global solution.

  The Global Solution

  The global solution will have vast implications for investors. The center of the economic world will move eastward. Chinese and Indian investors, as well as others from the world’s emerging nations, will eventually own most of the world’s capital, as tens of trillions of dollars of assets will be transferred from the retirees of the United States, Japan, and Europe to the savers and producers of the emerging nations. The global solution also implies that the developed world will run large and increasing trade deficits with the developing world. The importation of foreign goods in exchange for our assets is an inevitable consequence of our demographically driven future.

  Those firms that understand and take advantage of the growth of world markets will be the most successful. As the globalization of the equity markets accelerates in the years ahead, international firms will become increasingly important to investors’ portfolios.

  Nevertheless, investors must be very mindful of the growth trap: the fastest-growing countries, just like the fastest-growing industries and firms, will not necessarily provide the best return. If investors get overly enthusiastic about the growth prospects of global firms and pay too high a price, their returns will be disappointing. The poor showing of those who put their funds in China, the world’s fastest-growing economy, attests to the power of the growth trap to sink investor returns.

  A New Approach to Investing

  The material contained in The Future for Investors is a natural extension of my last book, Stocks for the Long Run. That research established that over long periods of time not only do stock returns overwhelm fixed-income assets but, once inflation is taken into account, also do so with less risk.

  My new research explores which stocks will outperform in the long run and shows that the traditional way that investors think about stocks, in terms of “international” firms and “domestic” firms, “value” and “growth” stocks, is outmoded. As globalization spreads, where companies are headquartered will fade in importance. Firms may be headquartered in several countries, produce in yet others, and sell their products worldwide.

  Furthermore, the best long-term stocks will not fall clearly into a “value” or “growth” category. The best performers may be fast growers, but their valuations will always be reasonable relative to their growth. They will be run by managements that have built and maintained their reputations for quality products that are marketed on a worldwide basis.

  Plan of the Book

  This book is organized into five parts. In Parts 1 and 2 you will learn about the growth trap and come to understand which investment characteristics you should seek and which you should avoid when buying stocks. In Part 3 you will learn why dividends are crucial to your success as an investor. In Part 4 you will see my vision of the future for our economy and financial markets, while Part 5 will tell you how to structure your portfolio to prepare for the changes that we shall encounter.

  In a world that stands on the brink of a radical transformation, The Future for Investors establishes a consistent framework for understanding world markets and offers strategies designed to protect and enhance your long-term capital.

  CHAPTER TWO

  Creative Destruction or Destruction of the Creative?

  The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.… This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.

  —Joseph Schumpeter, Capitalism, Freedom, and Democracy, 1942

  “Which Stocks Should I Buy and Hold?”

  The research presented in this book concludes that many investors have been making investment decisions based on the wrong assumptions about what drives stock returns. The journey that changed my views of investing began with a question I received after one of my presentations to a group of investors.

  “Professor Siegel?” A hand in the audience popped up, “You make a convincing case in your book Stocks for the Long Run that stocks represent the single best asset class over long periods of time. As a quote on the jacket of your book states, you have written the ‘buy-and-hold bible’ for investors. But I am still not certain what to do. Which specific stocks are you recommending that I buy and hold? Should I buy stock in, say, twenty large companies and just hold on to those shares forever?”

  “Of course not,” I replied, having heard this question countless times before. “The returns that I quote in Stocks for the Long Run are identical to those used by academics and professionals and are derived from very broad indexes of common stocks, such as the S&P 500 Index or the Wilshire 5000. These indexes are continually replenished with new companies, and now it is easy for investors to match the returns of these broad-based market indicators with indexed mutual and exchange-traded funds.

  “New companies are important to your returns. Our economy is dynamic: new firms and industries continually appear while old ones die or are absorbed by other firms. This process of creative destruction is the essential fact about capitalism.

  “Let me give you an example. The financial sector is the largest sector in the S&P 500 Index today. Yet in 1957, when the S&P 500 Index was founded, there was not a single commercial bank, brokerage firm, or investment bank traded on the New York Stock Exchange. In 1957 health care, which is now the second largest sector, was only about 1 percent of the market. The technology sector was not much larger.

  “Today these three sectors—financial, health care, and technology, which were virtually nonexistent in 1957—add up to more than one-half of the market capitalization of the S&P 500. If you never replenished your portfolio, it would be full of dying industrial firms, mining companies, and railroads.”

  Many in the auditorium nodded in agreement, and my questioner seemed very satisfied with my response. I was certain that the answer that I gave to his question would be approved by the vast majority of financial advisors and academics who studied historical stock market returns.

  Before my research for this book, I recommended that a straightforward indexing strategy was the best way to accumulate wealth. Being fully indexed meant that as the new firms came to the market and were included in the popular indexes, investors would be able to capture their superior performance.

  But over the last two years I have conducted significant and extensive research that has changed my thinking on this matter. The studies described in this chapter and the rest of the book, led me to realize that although indexing will still provide good returns, there is a better way to build wealth.

  Creative Destruction in the Stock Markets

  “Creative destruction” was the term that Joseph Schumpeter, the great Austrian-American economist, used to describe how new firms spearheaded economic progress by destroying older ones. Schumpeter claimed that innovative technologies trigger the rise of new firms and organizational structures whose fortunes increase as the established order declines. Indeed, much of our economic growth has come from the expansion of technology, financial, and health care industries amid the decline of the manufacturing sector. But is Schumpeter�
��s concept of creative destruction applicable to the returns in the financial markets as well?

  Yes, said Richard Foster and Sarah Kaplan, two partners at McKinsey & Co. In their 2001 best-seller, Creative Destruction: Why Companies That Are Built to Last Underperform the Market, and How to Successfully Transform Them, the authors wrote, “If today’s S&P 500 were made up of only those companies that were on the list when it was formed in 1957, the overall performance of the S&P 500 would have been about 20% less per year [emphasis in original] than it actually has been.”1

  If their research was correct, replenishing one’s portfolio with new firms was critical to achieving good returns in the market. The difference they reported was huge. When the magic of compounding is taken into account over the next half century, they claimed that $1,000 invested in the original S&P 500 firms would grow to less than 40 percent of the sum that would have accumulated in an updated, continually replenished S&P 500 Index.

  But something about Foster and Kaplan’s results deeply disturbed me. If the original “old” companies in the S&P 500 Index did so much worse than the overall index, then the newly added companies must have done much better. And if the difference between the returns on new and old companies was as large as Foster and Kaplan claimed, why wasn’t everyone just buying the new, selling the old, and substantially beating the S&P 500 Index? The overwhelming evidence was that most investors—indeed, most investment professionals—could not beat this benchmark.

  Looking Back to Find the Answer

  I decided that the best way to determine whether the concept of creative destruction applied to stock returns was to follow the performance of each of the original stocks in the S&P 500 Index. This would be a massive undertaking and the most data-intensive research I’d conducted since I first collected financial asset returns for Stocks for the Long Run. The analysis would involve not only calculating the return on the founding 500 stocks in the index but also tracing the complex corporate histories of the hundreds of successive firms that were merged or distributed from these original firms. Nevertheless, such a project would provide definitive evidence about the returns of “old” and “new” firms in the stock market.2

  Before we get into the details of the exhaustive study that changed my views of the best investment strategy, let us take a brief look at the history of the world’s most famous benchmark, the S&P 500 Index.

  The History of the S&P 500 Index

  Standard & Poor’s first developed industrywide stock price indexes in 1923 and three years later formulated the Composite Index, containing ninety stocks.3 As the economy grew, these ninety stocks proved insufficient to be representative of the whole market, so S&P expanded the Composite Index to 500 stocks on March 1, 1957, and renamed it the S&P 500 Index.4

  The index originally contained exactly 425 industrials, 25 railroads, and 50 utility firms. In 1988 Standard & Poor’s eliminated the fixed number of firms in each sector with the stated goal of maintaining a representative index that includes 500 “leading companies in leading industries of the economy.”5 The S&P 500 Index is continually updated by adding new firms that meet Standard & Poor’s criteria for market value, earnings, and liquidity while deleting an equal number that fall below these standards.

  The total number of new firms added to the S&P 500 Index from its inception in 1957 through 2003 was 917, an average of about twenty per year. The highest number of new firms added to the index in a single year occurred in 1976, when S&P added sixty firms, fifteen of which were banks and ten were insurance carriers. Until that year, the only financial stocks in the index in 1957 were consumer finance companies. Other financials were excluded because most were trading on the over-the-counter market, where timely price data were not available until the formation of Nasdaq in 1971.

  In 2000, at the peak of the technology bubble, forty-nine new firms were added to the index, the second highest total. In 2003, near the bottom of the subsequent bear market, the number of additions fell to a record-tying low of eight.6

  These additions and deletions have profoundly changed the composition of the index over the past half century. Table 2.1 displays the twenty stocks with the greatest market capitalization in the index today and in 1957, when the index originated. Five of the top twenty firms today—Microsoft, Wal-Mart, Intel, Cisco, and Dell—were not even in existence in 1957. Nine of the top twenty in 1957 were oil producers, while only two are today. Today the top twenty contains twelve firms in the technology, financial, and health care sectors, while in 1957 only IBM was in the top twenty.

  TABLE 2.1: LARGEST STOCKS IN S&P 500 INDEX IN MARCH 1957 AND DECEMBER 2003

  TABLE 2.1: LARGEST STOCKS IN S&P 500 INDEX IN MARCH 1957 AND DECEMBER 2003

  Portfolios of Original S&P 500 Firms

  To calculate the performance of the original S&P 500 firms, I formed three portfolios. All three portfolios start out holding the original five hundred stocks in proportion to their market value, a standard “value-weighted portfolio.” But over time these portfolios evolve differently depending on the assumptions we make about what investors would do when some of the original firms merge with other firms or distribute spin-offs.

  The first portfolio is called the Survivors portfolio and assumes that when the original firms merge or go private, the shares are sold and the proceeds are reinvested in the surviving firms of the index. This portfolio ended up with 125 companies and included such winning firms as Philip Morris, Pfizer, Coca-Cola, General Electric, and IBM and losers such as Bethlehem Steel, United Airlines, and Kmart.

  The second portfolio, called the Direct Descendants portfolio, included all merged firms, but it assumed, like the Survivors portfolio, that all corporate spin-offs were immediately sold and reinvested in the parent firm.7

  The third portfolio, called the Total Descendants portfolio, assumed that investors held all the corporate spin-offs. No shares from this portfolio were ever sold, so this is the ultimate buy-and-hold, or “buy-and-forget,” portfolio. By the end of 2003, the Total Descendants portfolio held shares in 341 firms; its composition is described in Figure 2.1.

  Long-term Returns

  I constructed these three portfolios to show that no matter how you define the returns on the portfolio of original S&P 500 stocks, you come up with the same astounding result:

  The returns on the original firms in the S&P 500 beat the returns on the standard, continually updated S&P 500 Index and did so with lower risk.

  FIGURE 2.1: FINAL PORTFOLIOS OF ORIGINAL S&P 500 FIRMS MARCH 1, 1957, TO DECEMBER 31, 2003

  From March 1, 1957, through December 31, 2003, money put in these original S&P 500 portfolios accumulated to between 21 and 26 percent more than would have accumulated in a standard S&P 500 Index fund. The results are summarized in Table 2.2.

  It should be stressed that all these returns could be attained by investors buying the original S&P 500 firms in 1957 and holding them to the end of 2003. No advance knowledge of which firms survived and which did not was necessary to obtain these index-beating returns.

  Let us put these results another way:

  TABLE 2.2: PERFORMANCE OF ORIGINAL S&P 500 PORTFOLIOS AND INDEX

  The shares of the original S&P 500 firms have, on average, outperformed the nearly 1,000 new firms that have been added to the index over the subsequent half century.

  I do not deny that these new firms that have been added to the S&P 500 Index drive the creative destruction process that stimulates economic growth. But on the whole, these new firms did not serve investors well. Those who bought the original 500 firms and never sold any of them outperformed not only the world’s most famous benchmark stock index but also the performance of most money managers and actively managed equity funds.

  Reasons for Underperformance of the S&P 500 Index

  Why did this happen? How could the new companies that fueled our economic growth and made America the preeminent economy in the world underperform the older firms?

  The answer is simple.
Although the earnings, sales, and even market values of the new firms grew faster than those of the older firms, the price investors paid for these stocks was simply too high to generate good returns. These higher prices meant lower dividend yields and therefore fewer shares accumulated through reinvesting dividends.

  Recall my analysis of Standard Oil of New Jersey and IBM in the first chapter. IBM was one of the most innovative and fastest-growing stocks of the twentieth century, and it beat Standard Oil in every growth category imaginable. But IBM could not beat the oil company’s return to its investors. IBM’s share price was consistently too high to overcome the gains made by reinvesting the oil company’s dividends. This was the same fate that on average impacted the 917 new firms added to the S&P 500 Index over the past half century.

  The overpricing, and resultant underperformance, of the new firms in the index is not the fault of Standard & Poor’s or the members of its Index Committee, which chooses the stocks in its indexes. In fact, S&P wisely resisted adding a number of Internet and technology firms to the index in the late 1990s, although some of these stocks attained market values far in excess of minimum requirement to belong to the index.

  As I shall show numerous times throughout the book, overpricing of new stocks is common throughout the entire market and is indicative of the growth trap. When euphoria strikes a particular sector of the market, as it did with technology in the late 1990s or oil and gas exploration firms twenty years earlier, it is impossible for S&P to avoid including some of these stocks in its index. In order for the S&P 500 or any other index to remain representative, it must admit firms whether or not it considers them overvalued.