Under-priced slower-growing dividend-paying stocks are often better investments than fast-growing companies. Investors often pay too much for promising growth stocks.
Jeremy Siegel is a finance professor at the Wharton School of the University of Pennsylvania. He is also the author of Stocks for the Long Run. In this book professor Siegel asks, “What criteria can investors use to choose stocks with superior returns that will outperform the market?” Investors are inevitably drawn to firms able to generate high earnings and revenue growth. But empirical data show this pursuit of growth often leads to sub-par returns.
Here’s your choice
Professor Siegel writes, “Imagine for a moment that you are an investor in 1950, at the dawn of the computer age. You have $1,000 to invest and are given the choice of two stocks: Standard Oil of New Jersey (now ExxonMobil) or a much smaller promising new company called International Business Machines (IBM). You will instruct the stock that you choose to reinvest all dividends paid back into new shares, and you will put your investment under lock and key for the next 62 years, to be distributed at the end of 2012 to your great-grandchildren or to your favorite charity.
“Let us assume that to help you with your decision, a genie presents you with a table, which displays the actual growth data of these two firms over the next 62 years.
IBM won on all measures of growth
“The table shows that IBM beat Standard Oil by wide margins on every growth measure that Wall Street uses to pick stocks: sales, earnings, dividends and sector expansion. IBM’s earnings per share growth, Wall Street’s favorite stock-picking criterion, was more than 3 percentage points per year above the oil giant’s earnings growth over the next six decades.
“As information technology advanced and technology became more important to our economy, the technology sector rose from 3 per cent of the market to nearly 20 per cent.
“In contrast, the oil industry’s share of the market shrank dramatically. Over this period, oil stocks made up about 20 per cent of the market value of all US stocks in 1950. But the group fell to nearly half that value or just a little more than 10 per cent of all US stocks in 2012.
“By these growth criteria, IBM stock should be a slam dunk to win investors’ favour. But Standard Oil proved to be the better stock to buy. Although both stocks did well, investors in Standard Oil earned more than 1 percentage point per year over IBM. When your lock-box was opened 62 years later, the $1,000 you invested in the oil giant would be worth $1,620,000, more than twice as much as IBM. What could you do with an extra $3.1 million dollars?
“Why did Standard Oil beat IBM when it fell far short in every growth category? One simple reason: valuation, the price you pay for the earnings and dividends you receive. The price investors paid for IBM was just too high. Even though the computer giant trumped Standard Oil on growth, Standard Oil trumped IBM on valuation, and valuation determines investor returns.
Standard Oil was much cheaper
“The average price/earnings ratio of Standard Oil was almost half of IBM’s ratio, and the oil company’s dividend yield was more than 2 percentage points higher.
“Dividends are a critical factor driving investor returns. Because Standard Oil’s price was low and its dividend yield much higher than that of IBM, those who bought its stock and reinvested the oil company’s dividends accumulated 12.7 times the number of shares they started out with, while investors in IBM accumulated only 3.3 times their original shares.
“Although the price of Standard Oil’s stock appreciated at a rate that was more than 2 percentage points lower than the price of IBM’s stock, its higher dividend yield made the oil giant the winner for investors.”
The fact is, as professor Siegel demonstrates, valuation often matters more than growth.
This is an edited version of an article that was originally published for subscribers in the September 17, 2021, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
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