TCS Daily


What Is the Future for Investors?

By Nick Schulz - May 5, 2005 12:00 AM

Wharton Business School Professor Jeremy Siegel is one of the world's most important scholars on stock ownership and investing. His 1994 book "Stocks for the Long Run" became an instant classic. His extensive original research found that over periods of 20 or more years, stocks are not only the best investment for your money, but the safest as well, returning 6.5 -7% after inflation (now popularly called "Siegel's constant") while bonds and other investment vehicles fared considerably less well.

Siegel is back with a new book, "The Future for Investors: Why the Tried and True Triumph Over the Old and New." He recently sat down for an interview with TCS editor Nick Schulz.

SCHULZ: Professor Siegel, thanks for joining us. You say in your book that investors are needlessly fixated on growth and too often fall into what you call "the growth trap." Can you explain what you mean?

SIEGEL: The growth trap is falling into a pattern of just buying companies with what you think are the fastest growing earnings, and ignoring the price. It is so important to realize that when you're paying a higher than usual price, you're already putting up for those higher earnings. In fact, I find that the faster growing companies often give poorer returns for investors; those investors that chase after those fast growing companies actually suffer worse returns than those that buy slower growing companies at reasonable prices.

SCHULZ: You have an excellent illustration of this in your book. In a section on history's best long-term stocks you bring readers back to 1950 to look at two stocks. You look at an old industry lion, Standard Oil of New Jersey. And then, you look at a new economy, juggernaut, IBM. And you look at these companies in 1950 right before there was going to be this great computer revolution and a digital and technological boom in the United States. From an investor's perspective, what did you find when you looked at those two?

SIEGEL: This surprised me. Even though IBM won, hands-down, on all the growth parameters that Wall Street looks at -- earnings per share growth, market value growth, sales -- it fell behind Standard Oil of New Jersey in terms of return for investor. And the two reasons for that: IBM sold at more than twice the price-earnings ratio of Standard Oil and had less the half the dividend rate. So when you put those two together, over the next 53 years, Standard Oil of New Jersey -- and this is even before the very latest run-up in oil prices, because I ended my first data set in 2003 -- out-performed IBM even though IBM was one of the fastest growing companies in the world.

SCHULZ: So if you're in an investor, and you're trying to analyze these two in 1950, how would you have gone about making a decision? I think most investors would say, 'well I would want to go with IBM...'

SIEGEL: Right.

SCHULZ: It was in on the beginning of this huge wave in technological innovation and growth, and they might be surprised by this. So how as an investor could you go about looking at these two companies in deciding which to invest in?

SIEGEL: Well the critical thing you would look at is the price-earnings ratio. And that is still, what I consider the old reliable yardstick for valuation. What you would've found was, yeah, IBM had better prospects but those better prospects were already embedded in the price that you were paying; and back them IBM was selling at 30, 40 times earnings. Start-ups can sell at much higher PE's -- in fact many of them don't even have earnings to start out with. But once you get to those big-size companies, I would really stay away from anything that's over 35, 40 times earnings; they very rarely give you good returns.

SCHULZ: These individual illustrations are helpful for investors, so I'd just like to turn to another one. One of the best-performing stocks of all time might surprise some people because it has been a controversial company for many years.

SIEGEL: Absolutely. It surprised me. From 1957, when the S & P was founded, to the present, the best performing company is Philip Morris, which is now the Altria Group. It won hands-down against all the others. The returns were three percent per year more than the next best-performing stock and almost doubled the S & P over the last half century, which is really remarkable when you consider the record.

And a major reason for that performance is that no one wanted to buy it. The price stayed low. First off, there are those who object morally to cigarettes so they don't buy it. And, more importantly, those that said, oh, the government's going to put them out of business; these liability payments -- Philip Morris has already paid over $150 billion! And, as a result, the price fell so low. They were still pumping out cash and the dividend yield got to be extremely high. And, once you had reinvested dividends, the returns on that company just soared above everything else.

SCHULZ: Now in your last book, Stocks For The Long Run, you recommended a straightforward indexing strategy for investors. But recent research that you've done, in the run-up to your new book, has prompted you to shift your advice a little bit.

SIEGEL: I used to advocate straight indexing the whole portfolio -- go to the Wilshire 5000 Index. And I suggested a few little strategies that might enhance performance but they weren't important.

But when I wrote this book I saw how important value-based strategies are. I now am saying that 50 percent of your portfolio should be indexed to the world market -- not just the US but the world market; the other 50 should be in diversified strategies that take advantage of this value-based approach with high dividends and low price-earnings ratios. It's what I call the tried-and-true, the corporate El Dorado's -- those good, consumer-staple stocks with brand names and international orientations on their sales.

SCHULZ: You touched on international a little bit and I want to shift gears and focus on another major portion of your book which looks at demography trends and looks at the global picture as it relates to investors.

You write in your book: "looming in the future are changes more fundamental, and long-lasting, than all the crises that have confronted our economy in the past."

That sounds troubling especially for investors. What exactly are you talking about?

SIEGEL: What I am talking about is the aging of the population, the fact that the number of workers per retiree is going to go down, drastically, even much more drastically in Japan and Europe, than the United States. But the whole developed world, which now produces three-quarters of the world output, is going into a very rapid aging phase that's really going to change the character of their economies.

And that's why I believe the rest of the world -- which is a much younger world -- is going to loom as a far more important piece of the entire growth puzzle and as a part of investor's portfolios.

SCHULZ: Now despite the quote that I just mentioned earlier, which sounds so doom-and-gloom, you're optimistic in your book. You say that there's a solution to this age-wave problem and you give it a specific name.

SIEGEL: The best solution of the aging problem is what I call the 'global solution.' I think that we have to think of ourselves very much like Florida, which is an aging state. In a younger country, we don't talk about an aging crisis in the state of Florida. Their retirees sell their assets in the US to the rest of the US market that absorbs them. They import goods. They're enjoying a good retirement.

In 50 years the United States will be more aged than all of Florida is today, but we will be, existing in a younger world. So, what I see is exactly the same pattern. We will be selling assets into the world market. They will be buying, they will be absorbing, they will be saving, and they will be producing the goods that we will be importing to satisfy our retirement needs. And, I think that is the only way that we could have an ever-increasing retirement period with the shrinkage of workers and the extension of life expectancy.

SCHULZ: Now what are some of the countries that you see being these places where they'll be buying assets and producing the goods that an older United States is going need and enjoy?

SIEGEL: Certainly India is very young country. The rest of Asia is a very young. Indonesia is very young. And even China -- I know that because of its one-child policy it is aging, but they have a huge supply of surplus labor with state-owned enterprises that they can absorb into the private sector. I expect, and I hope, that this development not only sweeps through Asia, which looks extremely promising, but also Latin America, the Middle East, and even Africa, which has been the so-called basket case. But there are a billion people in Africa -- very young ages -- and they have not yet started their growth.

India and China, by the middle of the century, will together be, in my opinion, more than four times the size of the United States.

SCHULZ: Are there policy changes that the developing nations like India or China or Brazil or Indonesia should be adopting, in order to ensure that they can grow, raise their living standards and increase productivity?

SIEGEL: Oh, absolutely. First of all, keep in mind that the United States needs to keep the markets open; we don't want to impose tariffs, etc. That would be detrimental to us into the future.

But these countries also will have to make changes. I expect some degree of democratization in China. Property rights are critical and the reduction in corruption is also critical. The ability of new firms to form without undue red tape and interference from government bureaucracies. These are critical steps that I think will enable these countries to take off and be a success in the future.

And with the Internet and all the rest of the newer technologies at their disposal, I see growth in the next 20 to 30 years on a worldwide basis being faster than ever before in our world's history. We have to realize China, Japan, the United States, and Europe are only 15 to 20 percent of the population. We have led the first charge. We had a monopoly on knowledge and information with the Internet and with the communications revolution. Today, this information is reaching into Asia where incredible developments in China and India and elsewhere are going to spark increased productivity, invention, discovery, and innovation that I think is going to make productivity grow more rapid -- on a worldwide basis, not necessarily just in the aging countries but, particularly in the other countries -- than we've ever seen before.

SCHULZ: You mentioned property protections. You mentioned innovation. How important are intellectual property protections to ensuring that these economies stay dynamic and robust and continue to grow?

SIEGEL: We want the extension of technology into these areas, which is very, very positive; but we also want to protect enough of the rights so people won't say hey, I can't produce anything if it's going to be stolen right away. So, you've got to balance those two. And economists are trying to find what is the right line of that balance. But clearly intellectual property has to have some protection to originate. And if we can get some sort of laws on the book it's going to be the Chinese that are going to start inventing. And they won't want anyone else to steal, if they can see both sides of the coin; so we might get some progress in that direction.

SCHULZ: One of the things that being debated in Washington that's of interest to investors is Social Security and the Bush Administration's discussion of private accounts. What is your take on that as you look at the Social Security system?

SIEGEL: I'm very in favor of personal accounts. I'm not so much because they can put money into stocks. Everyone said 'Jeremy, you wrote Stocks for the Long Run, you must be so excited' at the prospect of private accounts. I said, listen, the more important thing is that the people who put their money in, they believe that it is there. Establish that the money you put in, even if it's in bonds, as long as it's ranked as your money, I think that is a political win.

Because right now money goes away, it's a black hole; it may or may not be mine. I think the most important thing is personal ownership of the money you put in to the pension system, just like you have protections on the private pension system.

SCHULZ: You write "no one can deny the importance of technology, it's development has been the single greatest force, in human history." Can you just elaborate on the central importance of technology?

SIEGEL: Technology is critical for progress. For increases in standard of living, what we call growth, it is so very important; but that doesn't mean that technology stocks are the best stocks to buy. Just like not always the best horse on paper is what you should bet on at the race track. The horse could be over-bet and as a result the odds are way too low. You've got to look at the price, as well. Too many people just look at one, without looking at the other. Technology is an unbelievable force -- the communications and Internet revolution is one of the most exciting things to ever happen. Do I want to go into those stocks? Maybe, maybe not. I want to see what people are paying for them. If everyone else is excited about something, I tend not to want it.

SCHULZ: Who are your heroes?

SIEGEL: A person that I have respected throughout my life and had a deep impression on my life is Milton Friedman.

I was a colleague of his I was honored to be a colleague of his the University of Chicago. I was there from '72 to '76, the last four years that he was there. I read Capitalism and Freedom as an undergraduate at Columbia. I was moved by it. I saw the force of individuals working, how they could reach such tremendous heights; I saw government as oftentimes thwarting those developments -- although we could talk about what they have to do. And I just though he was so refreshing.

And he's such a nice person when I personally got to know him. We maintained our friendship all through the years; when I go to San Francisco I always visit him.

SCHULZ: Professor Siegel thank you so much for talking with us.

SIEGEL: Thank you, it was wonderful.

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