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Jeremy Siegel’s ‘Growth Trap’

Market Summary – 4th Quarter, 2004

Professor Jeremy Siegel of the Wharton School of Business made a name for himself in the 1990s with his best-selling book “Stocks for the Long Run.” The main point of Prof. Siegel’s enjoyable read was that historically speaking, stocks offer advantages over other types of investments when it comes to accumulating wealth. No argument from us on that.

The book, and its vast array of charts and graphs, showing the good Professor’s wealth of knowledge and historical research on the subject, helped him become a media celebrity. It seemed whether you turned on CNBC, National Public Radio or opened the business pages, you would see him quoted again and again. And why not? He represented not a profit-driven brokerage firm, but a wise academician with no apparent ax to grind.

While we don’t question much of what Prof. Siegel has to say as far as he goes, the ironic point is that his original book just didn’t go far enough. While stocks are the wise long run investment for most, the fact is that not all stocks make equal sense. That’s what separates the successful investors from the rest. We would have preferred more emphasis in his first book on how the price paid for a stock has a big impact on the return an investor actually achieves.

Seeing more eye-to-eye

With the publication of his new book, “The Future of Investors,” Prof. Siegel appears to have sharpened his vision just a bit. Among other issues, he indicates that searching for good value in a stock makes a lot of sense.

In a recent interview, he made this telling point. “The constant pursuit of growth – buying hot stocks or sectors or seeking out the next big thing – dooms investors to poor returns.” As Prof. Siegel himself says, “the tried and true beat the hot and new.”

4104 chartAccording to his calculations, paying attention to the price you pay for a stock makes a real difference. What we mean by price is not its actual cost in dollars and cents, but how the stock is valued. As you can see in the chart, stocks with a lower price/earnings ratio performed much better over time than those with the highest price/earnings ratio. Prof. Siegel’s study begins with $1,000 invested in 1957 (when the S&P 500 was officially formed). Each year, the portfolio of highest P/E stocks and lowest P/E stocks is rebalanced to reflect changes within the S&P 500.

In his book, Prof. Siegel illustrates his point by comparing two big-name stocks, IBM and Standard Oil. Even in 1950, Standard Oil of New Jersey (now Exxon Mobil) was considered an old-line business, a solid performer, but nothing to get excited about. IBM, on the other hand, was becoming a big-time technology stock.

So what happened? From 1950 to 2003, both stocks delivered double-digit returns. But Standard Oil gained an average of 14.4% per year, actually outpacing IBM’s annualized return of 13.8%. For every $1,000 invested in each stock in 1950, that roughly half-point difference in yearly return gave the Standard Oil investor a $300,000 advantage by the end of 2003. This comparison is strikingly noteworthy because the example he used for a prototypical growth stock, IBM, was no dog. The company enjoyed tremendous performance in that time. From every basic measurement of business, IBM had it all over Standard Oil. Looking at measures such as average annual sales growth per share (12.2% for IBM for 8% for Standard Oil), earnings per share (10.9% vs. 7.5%) and price appreciation (11.4% vs. 8.8%), IBM showed its true growth stripes. What’s more, the technology sector it represents grew from 3% of the total stock market in 1950 to 18% of the market today. During that same period, the oil industry went from a dominant 20% position in 1950 to just 5% today. So what gave investors in Standard Oil an advantage over time?

Prof. Siegel attributes the “win” to one simple fact – investors had higher expectations for IBM stock, and therefore, paid too much for it. He calls this the “growth trap.”

Expectations for Standard Oil were more modest, and therefore, its price reflected the general lack of enthusiasm. Yet steady company performance resulted in solid stock returns. In this particular example, a consistently high dividend also contributed greatly to Standard Oil’s edge.

Makes you wonder whether people are looking at today’s technology wonders with similarly “google-y” eyes. Is a stock like Google really worth its price today? Or is somebody who pays close to $200 per share for a very young company in a very unproven business setting their own growth trap? On the other hand, a tried-and-true company in our portfolio, Altria (once known under the far more scandalous name of Phillip Morris) has delivered solid returns and healthy dividends, and still seems attractively priced. In the game of expectations, Google is everything, Altria is nothing. In other words, a stock like Altria could be right where we want it to be (legal woes notwithstanding).

4q04 cartoonWe’re happy to see Prof. Siegel quantify a subject so near and dear to our hearts. He recently wrote, “there is no such thing as a ‘buy at any price.’ Buying stocks with proven long-term growth potential at moderate valuations is the key to a winning strategy.”

Ditto that, Professor!

There’s more to value
The price/earnings (P/E) ratio used by Prof. Siegel to make his point is the most popular measure of a stock’s value. While we consider ourselves to be value investors, we are not all that enamored with this famous statistic. On the face of it, comparing the price of a stock to the underlying earnings of a company is perfectly sensible. But for too many companies, the “e” part of the equation can all too easily turn into fuzzy math.

The difficulty is that there is no consistent definition of earnings from one company to the next. Some firms play it straight, but others, as we’ve learned over the past few years, like to play some games with how they report their earnings.

This isn’t to imply that companies are necessarily doing anything illegal. Thankfully, there aren’t a whole lot of Enrons out there. But the accountants can find clever ways to fudge with earnings reports in order to achieve a particular outcome. In some cases, a company may write down a major loss when it reports its earnings for a quarter. That results in earnings that are a major aberration from their normal reporting. In a given quarter, a company could experience drastically reduced earnings, and its P/E ratio will skyrocket. Or, a company may report an unusually good quarter due to a unique or one-time event, which gives it a deceptively attractive P/E ratio.

Investors should not be solely focus on the state of a company’s earnings. There are other meaningful measures. One that we like, for instance, is price-to-sales ratio. Companies need to sell product to generate profits and keep growing. Sales numbers are hard to disguise. They are a true indicator of how well a company is doing in the current business and economic environment. If a stock has become unpopular enough, its price/sales ratio can become extremely attractive. If sales hold up and profit margins expand, a stock with a low price/sales ratio can generate gangbuster returns.

Another approach is to look at a company’s price-to-book value. If a stock price is driven down because a company is out of favor, but the underlying value of the company remains strong, the time will come when investors recognize that a company is worth more than the market’s price. Tangible book value is another number that can’t be manipulated as easily as their earnings report (however, companies sometimes play games with intangibles, such as goodwill, to try to paint a rosier-than-deserved picture). Firms with a low price-to-book value are often good targets for a takeover, which almost always works wonders for the targeted company’s stock.

Measuring up for the long run
Prof. Siegel was generally on the right track with his “Stocks for the Long Run” creed. But some of his details were caught up in the rush to buy the hot stocks of the 1990s. Now, the Professor has changed his tune, at least slightly, and declared that it can be dangerous to pay too much for a stock.

At MPMG, our approach has been consistent. It wasn’t always popular as the market’s bubble grew bigger, but the value of value investing became far more evident once that bubble burst. This chart shows that since the bull market of the 1990s, when growth stocks outperformed value stocks (based on these two groups within the S&P 500), value has been back in favor.

If you believe that owning stocks is beneficial for the long run, the benefit will be far greater if your investment discipline remains consistent. We believe that history tells us a lot, and the history of the stock market keeps coming back to one simple point – the best way to make money on a stock is to pay the right price for it in the first place.

4q04 stock chart4th Quarter Review
If you want evidence that conventional wisdom (or “CW”) doesn’t add up to a hill of beans, you need look no further than the fact that the Federal Reserve repeatedly boosted short-term interest rates, and investors didn’t seem to care. The “CW” would tell us that if the Fed is trying to thwart an inflation risk by boosting interest rates, investors become nervous. Stocks should lose value, interest rates on long-term bonds should rise and it will be a rugged time for investors.

Throw in the fact that the dollar continues to decline, a sign of lagging confidence in the U.S. economy and concern about the burgeoning government debt, and the environment for investors should have been tenuous at best during the fourth quarter.

But there was one, singular event that appeared to put investors back on track – the end of the election. Whether they were pleased with the outcome or not, the sense of relief many of us felt to have the political rhetoric simmer down, at least for a few weeks, was palpable. With no more need to write out checks to Bush/Cheney or Kerry/Edwards or Swift Boat Veterans or Moveon.org, money was finally available to put back into the markets.

Another development of note during the quarter was that energy prices, which skyrocketed well into the autumn months, finally leveled off. Those who’ve read our previous newsletters know that we’ve spoken of what we see as a long-term trend of higher energy costs. We’re not surprised that in the short run, prices have come back to earth. But the fact remains that demand for energy around the world is most likely heading up and resources aren’t going to grow at the same rate. Prices will always be
volatile, and right now, we’re getting a reprieve at the gas pump. But longer term, in our opinion price pressures will resume, and so will those $40 to $50 visits to the corner station.

Stocks of Note
PerkinElmer (PKI – $21.37) – The infant mortality rate in the U.S. has declined significantly in recent decades, but still is about seven in every 1,000 live births. Parents and physicians are anxious to know as quickly as possible if a newborn child is confronting a medical problem. Among its many businesses, genetic screening tests represent less than 10% of revenue for PerkinElmer. However, this looks to be the fastest-growing part of the company. A series of 30 genetic screening tests costing less than $100 is available from PerkinElmer, and many parents opt to have the tests done. In fact, there is a proposal that states require such testing. This business seems to have tremendous upside, and the good news is that PerkinElmer holds a 45% market share in it. Even though the stock has performed quite well in recent months, the bright future for genetic testing holds additional promise for strong profits.

Laureate Education (LAUR – $43.82) – We tend to think of college education as involving either a public university or a private one, but not a corporate one. Laureate is a company in the business of providing students worldwide with a college education. It operates 14 accredited universities with more than 40 campuses in countries around Europe and Latin America. It is by far the biggest player in this field, and 150,000 students attend its universities or take advantage of its online programs. Laureate benefits from the fact that the regulatory environment is much looser in most foreign countries in terms of post-secondary education. Enrollment is booming and it appears that the demand for higher learning among young adults worldwide is on the march. In this case, we’re all for more academic types, and continue to expect big things from Laureate.

The opportunities ahead
Although the political season is over, this is a year when we may see some real fireworks that could have an impact on the markets. Proposals regarding tax code simplification are likely to come down the pike, and the big talk as 2005 begins is whether some form of Social Security “privatization” will take root. Either topic is likely to have a bearing on the mood of investors, but don’t expect any major developments to occur overnight.

The Federal Reserve appears convinced that an inflation threat remains, so it is likely to bump interest rates some more in 2005. Whether this will take a toll on the stock market is difficult to judge. The dollar was reaching record low levels as the new year began. These events all have some impact on day-to-day movements in the market, but are likely to have little effect on the long-term outlook for investors.

If anything, the biggest challenge for value investors like us is that the year-end rally in stocks failed to create many obvious discounts for us bargain-hunters. Like the Christmas shoppers who wait until after the holiday to cash in on bargains, we’re willing to be patient and wait for better deals when they arise.

What appears quite likely is that 2005 isn’t going to be the kind of environment where a “rising tide lifts all boats.” Our focus on paying the right price seems to make the most sense, especially in an environment where prices for some stocks seem harder to justify given current economic conditions.


Stock prices as of close of trading, 1/7/05.

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.