Siegel interview
GEOFF COLVIN: It isn’t often that a famous and highly respected authority announces new findings that are practically guaranteed to change your most fundamental views about investing. But hold on, because some of those views are about to get shot down.
Looking for innovative, fast-growing firms to invest in? You shouldn’t be. Fighting to get a piece of the hottest new IPO? Don’t waste your time. Resigned to accepting the returns of index funds?There is an even better approach.
Jeremy Siegel of Wharton wrote an investing classic, Stocks for the Long Run, and his new book, The Future for Investors, may be even more influential.
Jeremy, you start shooting down the core beliefs of many investors with the subtitle of this book, which is: Why the Tried and True Triumph over the Bold and New. What do you mean by that?
JEREMY SIEGEL: It surprised me also. I used to think that one of the reasons the S&P 500 gave such good returns was all the new firms that kept on being added…
COLVIN: Yes, people should realize that index is consistently being refreshed with new firms.
SIEGEL: Updated, yeah. In fact since its founding in 1957, there’s been almost 1,000 new firms that have been added. You know, Intel, Microsoft and all the rest. What I’ve found actually is the old original ones taken as a group actually outperformed all the new firms that came in the last half of the century.
COLVIN: You mean if you had bought the S&P 500 firms in 1957 and just held them and forgotten about all the companies that came into it since then, you would have beaten the S&P 500 index with all the firms that have been added?
SIEGEL: Yeah, absolutely. And we know the S&P 500 index beats most money managers. It’s a very hard bogey for them to match. So it is really surprising. Just those original companies, follow through all the mergers and all the acquisitions, you beat the dynamic, updated S&P 500 index.
COLVIN: Well, now this is just stunning. Of course the question is why, and you looked into that. Why?
SIEGEL: The major reason is that firms that have been added to the index are overpriced. In 9 of the 10 sectors of the economy, I found that the new firms that were added subsequently to 1957 actually underperformed the original firm. It isn’t that they were growing any slower. In fact many of them were growing faster. It’s just that the public getting so excited about these firms, once they get to be a big market value, the S&P is induced to put them in the index. That’s the wrong time usually to buy a stock.
COLVIN: Okay, so this is where we really start shooting down investment beliefs held by so many, many people. Let me just state some of them, and you tell me what’s wrong with them. You want to invest in innovative, fast-growing firms.
SIEGEL: Well, what is wrong about that is everyone wants to invest in innovative, fast-growing firms, and they push up the price way too high. And no matter how fast a firm is growing, you must pay attention to the price. And I think that that’s so very, very important, missed by a lot of investors.
COLVIN: Well, in fact you have identified something that you call the growth trap. What is it?
SIEGEL: Yeah, that’s really the first chapter of the book, the Growth Trap. The growth trap is people thinking that the best performance they can do in the market is just picking those firms that grow the fastest or those sectors that grow the fastest, or as I find later in the book, even those countries that grow the fastest. And it turns out that very often those are the firms, the stocks that under-perform the market.
COLVIN: So they’re growing fast, profits are growing fast, right?
SIEGEL: Right.
COLVIN: But they’re bad investments.
SIEGEL: Because you’re paying too high a price. You know, I introduce early in the book a principle called the basic principle of investor returns, which basically says it’s not how fast the earnings of a company are growing; it’s how fast they’re growing relative to what investors had expected them to grow. That’s built into the price. That’s what we call the P/E ratio. You’ve got to look at both.
COLVIN: And so what follows from that I think so many people don’t understand is that even if profits grow slowly, if it’s a little faster than what was expected, it’s going to be a good investment.
SIEGEL: Oh, yes. I mean actually some of the great investors, Peter Lynch, and we know even Warren Buffett, they’re not always looking for the fastest-growing. They’re looking for the under-priced stocks, those that push out cash, they may be growing slower, but given their price, investors are going to come out ahead.
COLVIN: You did a very interesting exercise in this book, where you said let’s suppose it’s 1950, and you were supposed to decide am I going to invest in Standard Oil, a big, even then an old industry, an old company, really big, arguably best days behind it, or am I going to invest in IBM? In 1950 the dawn of the computer age, exciting, high-tech, and in fact we know that both companies have grown and survived and prospered. But what did you find when you looked at them as investments in 1950? And by the way, the conventional view would be well, obviously you would have chosen IBM, on the launching pad of the computer revolution.
SIEGEL: Absolutely. In fact, IBM earnings grew more than 3 percent per year faster than Standard Oil of New Jersey over the next half century. Their earnings grew faster, their dividends, their market value, their sales, but the winner was Standard Oil of New Jersey. An investor who bought that stock, reinvested the dividends -- and that’s a very important component of long-term returns, as I talk about later in the book -- reinvested those dividends, ended up with a greater amount of wealth than someone getting in on the greatest technology stock at the beginning of the computer age.
COLVIN: It is just stunning. Now you mentioned dividends, and this turns out to be another important point that contradicts another core belief of many investors, which is dividends are bad because your returns are getting taxed twice; one when the company earns the profits, and a second time when they’re paid to you as dividends. So it’s better to find companies that reinvest the cash rather than companies that pay it out in dividends. This turns out to be wrong.
SIEGEL: It turns out to be false. Now we have two things that we have to look at. President Bush, obviously we reduced that dividend tax, so that difference between capital gains and dividends is much smaller than it was before. But what I found was that the dividend reinvestment was that margin by which many of those so-called slower growing firms actually beat the faster growing firms in the long run. You know a lot of others say firms that pay dividends, they don’t have growth opportunities. Well, that proved to be wrong, too. A lot of those firms that used their cash for growth opportunities, actually they were buying overpriced firms, too. Then the technology industry, we saw that in ’98 and ’99, 2000. So it turns out returning that money to you, having you reinvest, the best proposition.
COLVIN: Even though you had to pay the tax on it, you were still better off.
SIEGEL: Most of the time you were still better off. Those dividend-paying firms really did better.
COLVIN: Well, this is all just getting more and more remarkable. So let’s move on to the next core belief of a lot of investors, which is if there’s an IPO, especially a sort of a hot IPO, if by the remotest chance you can get it at the offering price -- and of course most of us civilians cannot get it at the offering price -- but if you can get it at the offering price, you should absolutely grab it because these things virtually always go up.
SIEGEL: Yes, they go up, but sell it right away. Mom, don’t hold it. What’s really amazed me is I thought, well, if you got it at that offering price, it popped 100, 200, 300 percent, you’d be all right on the long run.
COLVIN: Because it would never go down so much.
SIEGEL: It would never go down by more than its IPO price or certainly not more than an index that was matched to small stocks. So what I did was looked at IPOs from 1968, all of them to the present. Let’s assume you bought all of them then, even from that offer price, got the pops when they did occur, you fell behind either the S&P or a small stock index over 90 percent of the time. It was really amazing.
COLVIN: It is really amazing.
SIEGEL: Because certainly once it pops, people know, hey, you know, that may be a too high price, but I thought if you bought them at that offer price, you’d still be good in the long run. No. They’re really hot potatoes. Get rid of them. Take your pop and be thankful.
COLVIN: All right. Let’s talk about sectors now, because this is the way a lot of people look at it. They say well, look, I’m going to identify the big picture, the fast-growing sectors. And you did this analysis, too.
SIEGEL: Yes.
COLVIN: Now you would think that if you buy a sector fund, right, and you have picked the fast-growing sectors, you’re going to get the losers but the winners also, and you’re probably going to do okay. Not true, right?
SIEGEL: Not always. In fact, of the fastest-growing sectors that we had -- we had the healthcare sector, we had the financial sector, an information technology sector -- only healthcare in the long run did well for investors. Financial actually, even though it was the biggest expanding sector from 1957 to the present, actually fell behind the market.
COLVIN: In investment returns to investors.
SIEGEL: In the S&P 500, fell behind in investment returns. And even information technology, it slightly did better, but that was only because of a few years of IBM performance right at the beginning of the index. All the new firms that have been added to that information technology index subsequently, as an average, underperformed the S&P 500.
COLVIN: You found something that just floored me, which was that the railroad sector outperformed the market?
SIEGEL: Right, the railroad sector. This is really amazing. Now of course the railroad sector took a big dip during the Depression, after the war. Everyone had given up on the rail sector. No one wanted to touch the rail sector. The thing is that the rails figured out how to make money, and they were turning really good dividends, and so they were really what we call deep value stocks. It wasn’t that they were growing so fast, but when you reinvested those dividends, I was so surprised it outperformed the average. By the way, another tremendous shrinking sector in terms of proportion of the market that also way outperformed was the energy sector. Over 25 percent of the market in 1957, less than 10 percent today, and yet it outperformed the S&P 500.
COLVIN: As an investment.
SIEGEL: As an investment.
COLVIN: Now in Stocks for the Long Run, your previous book, your advice to investors was you should take all of the money that you plan to put in stocks and put it in an index fund that tracks the broadest possible index of stocks. After this research, you have changed that advice. Is that right? And what is it now?
SIEGEL: Yes, well I still believe you need that diversification, so I say take half of your commitment and index it to the market. And by the way, there’s a very big international component there that I have raised. The other half I like going into investments with high dividends, low price/earnings ratios. I like energy sector, pharmaceutical sectors, consumer staples, brand name companies, expanding worldwide. Something I call the corporate El Dorados that have done so very, very well. I talk about the 20 best performing companies. Tilt your portfolio in that direction, and I think you’re going to get a couple percent or even more on these broad-based indices.
COLVIN: Above the indices.
SIEGEL: Above the indices.
COLVIN: And you call this specifically the DIV strategy, right?
SIEGEL: Yes.
COLVIN: Which stands for D is dividends…
SIEGEL: I is International, and international, a very heavy focus on international investing, and V is looking at valuation. The valuation, the price you’re paying for those stocks in terms of dividends and earnings.
COLVIN: Well, let’s talk about each one of them in a little bit of detail, because this is very helpful stuff. The D, dividends, look for companies that pay how big a dividend?
SIEGEL: Well, you know what I did was I looked at all the S&P companies from 1957 to the present. If you would have bought the 20 percent highest dividend payers and just rolled it around every year, you’d outperform the market by 3 percent a year for nearly a half century.
COLVIN: And three points a year for 50 years is mammoth.
SIEGEL: Oh, yeah. You’re going to be triple, quadruple the sum that you would be if you were just in the index. In Stocks for the Long Run, I said maybe 25 percent of your equity portfolio you should be international. I’ve now pushed that to 40 percent. I really believe a lot of the growth is going to be outside the United States in the next 20, 30, 40 years, and you’re going to need that diversification away from just having U.S. companies.
COLVIN: Well, and so when you say international, you mean companies based outside the United States?
SIEGEL: Headquarters outside the United States. In other words, either in Europe, obviously, or Japan. Something we call the EAFE index. We have to have emerging markets, but I caution you not to overweight there. But in other words, where the headquarters are not in the U.S. That’s the current definition, which I think might actually change in the future, but the current definition of where a company is located, not where it sells or where it produces, where the headquarters are located. I believe you should go up to 40 percent.
COLVIN: But you pointed out that if you invested in China, the fastest growing economy on earth, you wouldn’t have done so well.
SIEGEL: That was a shocker. You know, in 1992 to the present, 12 years, the fastest growing country by GDP, by virtually any measure, is China -- the worst dollar returns. And you know why? Again, everyone was so excited, including the Chinese, that they just bid the price of these stocks so high. They couldn’t last, gave people negative returns. Actually $1,000 invested then turned into $300 by the end of 2003.
COLVIN: It’s incredibly surprising. Okay, the V in DIV is Value.
SIEGEL: Is valuation.
COLVIN: And this of course is the great classic basis for investing. All of the most successful investors have done so on that basis. What’s your mechanism for identifying the stocks that a person should buy for the V part?
SIEGEL: Well, you know, there’s two groups of stocks that are important here. First of all, I did find that those that had the lowest price/earnings ratios did tend to outperform a value-based strategy. But there’s that group of stocks that grew very fast but had reasonable prices. I call them the corporate El Dorados. They were the 20 best performing companies of the original S&P 500 companies. They were fast growers, but the interesting thing is that investors paid only a couple points over the average price/earnings ratio for these stocks. We sometimes call these stocks GARP, growth for…
COLVIN: Growth at a reasonable price.
SIEGEL: Growth at a reasonable price. That group of companies that has a history, that has brand name, that has international exposure and is increasing their markets, I’ve found that those are value stocks in a slightly different way. Not that they’re low P/E stocks, but their P/Es are reasonable relative to their growth prospects.
COLVIN: Essentially they bucked the big trend that you identified. They were fast growing, and yet you didn’t have to pay a big price for them.
SIEGEL: Right, because many of the people said, oh yeah, this company is fairly good, but maybe I’ll give it 25 or 30 P/E while they were chasing these exciting technology and telecom and everything else at 70, 80, 90 P/E. Well, those other companies couldn’t match that price, but these companies were really well worth it. And it was interesting when I looked at that list with Philip Morris and the pharmaceuticals. Actually of the top 20 original companies in the S&P 500, 90 percent were in two sectors: pharmaceuticals and consumer staples, the brand names that are known around the world.
COLVIN: Brand names, right, perceived now as sort of non-sexy businesses.
SIEGEL: Oh, yeah, you know pharmaceuticals certainly have taken huge hits. On a historical basis, they’re about as cheap as you’re ever going to get them. So if you don’t think they’re going to fade away, there’s an opportunity there. But even the companies that have had this international exposure, brand name is so important in the developing world. In China and India they trust brand name. If you’ve got a skillful CEO that says I’ve got the brand names, you know, from Procter & Gamble to Coke to Pepsi, to Wrigley to Heinz, and we can keep on going down and down. Wow, those are the companies over time have produced tremendous returns.
COLVIN: It really is fascinating. Jeremy Siegel, thank you so much.
SIEGEL: Thank you, Geoff, for having me.
Creswell on Kinder Morgan
KAREN GIBBS:The kinds of companies Jeremy Siegel is referring to, those that perform well over time, usually dominate FORTUNE’s annual list of the most admired companies in America. They are businesses that excel at innovation, and financial soundness. That’s why the list is dominated by titans like Dell and General Electric, along with Starbucks, Wal-Mart and Southwest Airlines rounding out this year’s top five.
But in a week that saw the highest profile CEO yet convicted of fleecing investors -- WorldCom’s Bernie Ebbers -- it’s worth noting that the rising star on this year’s most admired list is Kinder Morgan -- a heretofore obscure pipeline company created from the ashes of none other than Enron. FORTUNE’s Julie Creswell explains.
JULIE CRESWELL: On the surface, when you look at Kinder Morgan, it’s a company that you wonder what you would like about this company. It’s an energy company based in Houston. It’s run by a former Enron executive, and it has a very complicated financial structure, which of course reminds all of us of another company named Enron. In reality, what Kinder Morgan is, it’s a real company with real great management and real great cash flow. It’s a company that owns pipeline assets. It owns and operates 35,000 miles of pipeline across the United States, and it moves gasoline and diesel fuel and jet fuel across those pipelines. And because of its structure, it spins off a lot of its cash flow back to investors. Right now investors in this stock are getting more than a 6 percent dividend yield off of it.
Rich Kinder, who was a former Enron executive, runs a very tight ship. You know, while Ken Lay was out there decorating private jets, Rich Kinder was traveling coach, staying in Red Roof Inns, and living a very frugal existence, and that shows in how this company performs.
There are absolutely people who believe if Rich Kinder had become the CEO of Enron, Enron would not have collapsed. It would not have gone into the direction that it went, i.e. a big reliance on energy trading. It would have continued to hold on to the hard, slower-growing assets like the pipelines that would have actually been something that it could have relied on for cash flow when the trading operations collapsed.
But back in the late 1990s when Ken Lay at Enron decided these were assets they no longer wanted, Rich Kinder was able to purchase those pipeline assets from Enron, walk away, and go and create a company with a market cap of $18 billion. Because of the way the company’s structured to avoid paying corporate taxes, they have to spin off or distribute their cash flow back to investors, which means investors are getting about a 6 percent dividend yield. And one of the things that Wall Street really likes about this company is that the company has been very steady about increasing that dividend over the years. So it’s been a company that’s just performed really well.
(taped segment ends )
NEXT WEEK: A Dollar Earned...
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