Eugene Flood interview
GIBBS: Fed Chairman Alan Greenspan has morphed into Alfred E. Newman, the "What me worry?" guy of Mad magazine. While some analysts have expressed concern about poor job growth and weak consumer confidence, the Fed chief this week dismissed those worries, saying the economy is on reasonably firm footing. That's Fed speak for higher interest rates to come.
But what will higher rates mean for the bond market, the housing market and the economy in general? Eugene Flood is CEO of Smith Breeden, managing money for pension funds, endowments and banks, among others.
Well, Gene, what was your reaction to Greenspan's comments? Do you see things as rosily as he does?
FLOOD: Well, I would say we're probably not quite as optimistic about where the economy's going as the chairman. We would say, however, that we believe the economy in general is healthy. So we are looking for growth to move from the 4 percent area, in terms of real GDP growth, to about the 3 to 3.25 percent area for 2005. So that's still fairly good growth, but just decelerating from the pace where we were last year.
GIBBS: Well, what's tempered your optimism and why do you see growth decelerating?
FLOOD: Well, there's really two reasons, Karen. On the corporate side, if we can just start there for a moment, growth last year was really quite fantastic for U.S. corporations. U.S. profits were running at about 24 or 25 percent, just tremendous. This year we see the profit growth, as measured by looking at the S&P 500 operating earnings, moving from that 24-25 percent area down to 8 percent or so, 8 to 10 percent. So considerable deceleration, but still okay. The reason that growth is going to slow, we believe, with the corporate sector is that it comes from rising prices, rising input prices. So if you look at the PPI, PPI is running at about…
GIBBS: That's the Producer Price Index.
FLOOD: The Producer Price Index is running at about 4.8 percent on a year-on-year basis right now. That's pretty high given that output prices, or the Consumer Price Index, is running at about 3.5 percent. So what that means is that corporations' input prices are going up faster than their output prices, so their margins are getting squeezed, and that's why profits are coming down.
Now on the consumer side, you know, we've started to feel a little bit like the boy who cried wolf in that we'd been saying for a while that the U.S. consumer is going to slow down. The two primary drivers there are higher interest rates, and consumers have financed so much of what they buy, and it's really driven the housing market as well, these low rates. So as rates rise, that will squeeze the consumer some. And then also if you look at energy costs, energy costs have really started to bite for consumers some. Oil prices have now really started to, high oil prices have started to turn into higher home heating energy prices as well as higher gasoline prices. So the combination of those two things we think will slow the consumer down eventually.
GIBBS: Eventually, but we have already started to see consumer confidence drop, and it is a function of, as you mentioned, corporations pulling back, not able to pass on much of the input increases that they're seeing, but they have been able to pass on something. And they're also sharply pulling back in terms of hiring. Doesn't that dent the consumer going forward not withstanding this housing market?
FLOOD: Well, it will tend to, those factors will tend to slow the consumer. But the biggest factor that is driving consumer behavior right now, and not so much consumer confidence as what they say but what they do, is the housing market. That's the biggest factor. And so with interest rates still relatively low by historical standards and income growth for consumers still fairly robust, that's been enough to support the housing sector.
Also another factor that supports the housing sector is innovations in mortgages, so many mortgages now have moved from the traditional 30-year fixed rate mortgage or 15-year fixed to one that has lower interest rates in the early years and then moves to a fixed higher rate later on. But with those lower early rates, consumers have been able to afford much larger houses. That has supported consumer confidence, because housing prices have been going up by so much, and it's also supported the consumer's ability to spend, because of course they've been refinancing, taking out equity, and then spending that equity.
GIBBS: But isn't it a double-edged sword now? We've got these incredibly low mortgage rates, and all of these products, like you mentioned, whether it's the adjustable rate mortgages or the interest only mortgages. But a tick up in interest rates is going to show some systemic risk and damages, not only to the housing market, but to the economy.
FLOOD: Well, it will slow the economy, and I think calling them systemic risks might be a little too strong, that we certainly believe that the economy is interest rate sensitive at this point. And the housing sector, as you point out, is a case in point, that as rates rise and turnover in housing starts to slow down and housing price appreciation starts to slow down, that takes away jobs that come from the mortgage lending sector, from the construction sector, etc., as well as it takes away some of the money that consumers have been spending, because they can't take out as much equity as they had in the past. So that will slow the economy, but the economy is, as I said, I think the economy is in fairly good shape.
GIBBS: Well, let's get back to this housing problem, well, not necessarily a problem, but the housing issue. A lot of people, because of the low interest rates, have bought huge homes. They've monetized it; they're using that equity from their house to continue to fuel buying things. A lot of people are buying homes that are right at the top, things that they couldn't afford with higher interest rates. Don't you see some risk to that? And as an aside question, because of the housing market's performance so far relative to the stock market, has it replaced the stock market as the investment of record for most consumers?
FLOOD: Yes, so first question, is there risk? There certainly is risk.
We think the economy is interest rate sensitive, and we think it's more interest rate sensitive than apparently the Federal Reserve does, because their comments have been, have suggested that they're not too concerned about the impact that rising rates will have on the housing sector. We think it's going to be fairly strong. We don't think that there's going to be a crash as if there might be when there's a bubble in markets where prices drop 15 or 20 or 30 percent. We don't think we're going to see that kind of outcome in general in the United States, maybe in some pockets, but not in general.
Now, second question, what about the housing market and has that replaced the stock market. In recent years it really has as the investment of choice for the consumer or for the individual. The reason is that if you look at what's going on with corporate profits right now, as we discussed, there's a deceleration in earnings.
And so if you invest in stocks at these multiples, you've got to be concerned about how much upside there could be. But housing has really been running because employment growth, while it hasn't been robust compared to historical periods, it's still been reasonably strong, and income growth has been moving at a pretty steady clip, 3 to 4 percent. That combined with the low rates has made housing kind of the obvious alternative to turn to.
GIBBS: All right. Gene Flood, it's a pleasure talking with you. Thanks for joining us.
FLOOD: Thanks, Karen.
Jeremy Siegel speaks
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?
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. International, 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: This is so interesting. We really appreciate it. Jeremy Siegel, thanks so much.
SIEGEL: Thank you for having me.
COLVIN: It really is fascinating. Jeremy Siegel, thank you so much.
SIEGEL: Thank you, Geoff, for having me.
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