Debating the "Growth Trap"


Editor's Note: In BusinessWeek's Feb. 14, 2005, issue Chief Economist Michael J. Mandel reviewed The Future for Investors, the latest book from author Jeremy J. Siegel, a finance professor at the University of Pennsylvania's Wharton School of Business. Mandel liked the book overall, praising it as provocative, valuable, and "well worth reading." But he took issue with one of its central tenets, that investors fare better by sticking with the "tried and true" than by gravitating toward the "bold and new" in technology and innovation.

We asked Siegel and Mandel to continue their discussion, with each getting a chance to respond to the other. See where you come out in this spirited exchange of views:

Siegel responds:

You can imagine my puzzlement when I read your review of my book, The Future for Investors in the Feb. 14 issue of BusinessWeek and saw the call-out, "Siegel's own figures don't support his anti-tech message." In truth, my book is both protechnology and progrowth. The first two sentences of the book read: "The future for investors is bright. Our world today stands at the brink of the greatest burst of invention, discovery, and economic growth ever known."

But being optimistic about technology's growth and future role in the economy doesn't mean one should necessarily buy tech stocks. Everything you buy must be evaluated against its price. For example, a restaurant that serves the best food may not be worth its exorbitant prices. The New England Patriots may be the best team in football, but no one should bet even money that they will win the next Super Bowl. And Smarty Jones was probably the fastest horse in the Belmont Stakes last year, but he was so overbet to win by a fawning public that he paid off more money to come in second than he would have had he come in first.

Betting on the "best" without knowing the odds is the same as buying the fastest-growing stock without looking at the price. I call this the growth trap.

The growth trap is one of the fundamental ideas in my book. Investors must always look at prices before they commit their funds. Investors will earn poor returns with faster-growing stocks if the price they paid is too high. The "basic principle of investor returns" that I describe in the third chapter states that the return to investors depends not on how fast earnings grow but on how fast earnings grow relative to what investors expected. The growth trap is probably the single biggest reason investors reap poor returns when buying individual stocks.

Unfortunately, by labeling my book "anti-tech," you have fallen victim to the very trap that I warn of in the book. We are both optimistic about technology's role in the world economy, but this does not mean tech stocks will lead the market upward. Just ask investors in telecom and the Internet whether the spectacular technological advances in their industries helped their investments.

Mandel responds to Siegel:

Yes, Professor Siegel, tech investors have suffered over the past few years.ut you should know better than anyone that the right way to judge investments is over a decade or more. And once we take a longer view, we see that investors in tech stocks have done very well.

Let's break it down. The economy has three main sectors where new technologies have played a key role over the past decade: health care, information technology, and telecom. Telecom stocks have obviously not done well.But from 1994 to today -- a period that includes both boom and bust -- the health-care sector produced an annual return of almost 15%,and the info-tech sector produced an annual return of 13%. Both of these beat the 12% return for the whole S&P 500-stock index. (These figures include reinvested dividends.)

The ordinary person reading your book would have no idea that 2 out of the 3 main technology sectors delivered superior returns over the past 10 years.

Or take a look at individual stocks. Over the past 10 years -- once again, a period including both boom and bust -- 6 out of the top 10 performing stocks in the S&P 100 were technology-related: Dell (DELL), MedImmune (MEDI), Cisco (CSCO), Amgen (AMGN), Medtronic (MDT), and Microsoft (MSFT).

In fact, there's no sign of a growth trap. Quite the opposite: Over the last 10 years, health care and info tech have been fast-growing sectors -- they produced a rising share of economic output, and the stocks in those sectors have done well on average. By contrast, telecom hasn't been a growth sector,despite all the press attention. According to the latest statistics from the Bureau of Economic Analysis, the telecom and broadcasting industry accounted for 2.57% of gross domestic product in 2003. That's a smaller share than it had in 1994, and the lack of growth in this sector has been reflected in the poor performance of the stocks.

The question is: What comes next? In my assessment, the telecom industry is ripe for a breakout on the upside. The new telecom technologies -- broadband and wireless -- are starting to mature and find new applications,and the share of the economy coming from telecom should finally start to rise.That's a plus for telecom stocks, not a minus.

Siegel retorts:

Mike, you note that since 1994 technology stocks have beaten the market. But as I clearly state on page 56 of The Future for Investors, "There was only one stretch in the last 45 years when expectations for earnings growth in the technology sector were below that for the overall market, and that was in the early 1990s, after three consecutive years of large losses by IBM (IBM)."

If we look at periods of longer than 10 years, the results are horrible for technology stocks. In the last 20 years, the technology sector trailed the market by more than 3 percentage points a year (10.17% for tech vs. 13.24% for the S&P 500 index). If we go back 30 years, technology trailed the S&P 500 by 11.52% to 13.74%. Even if we go back 40 years, technology trailed 9.48% vs. 10.5%. And these figures don't include the underperformance of tech so far this year.

You wrongly imply that, since I warn investors against the growth trap, I do not like health-care stocks. Health care is one of my favorite sectors -- a sector I recommend overweighting in your portfolio. I specifically point out that there were six surviving health-care stocks in the original S&P 500 index: Abbott Labs (ABT), Pfizer (PFE), Merck (MRK), Bristol-Myers (BMY), Schering (SGP), and American Home Products, and all of them were in the top 20 performing surviving stocks over the past 50 years.

The difference between the health-care sector and tech is that health-care stocks provided a combination of excellent growth that could be bought at reasonable prices, while tech stocks, except for in the early 1990s, were overpriced and yielded poor returns.

Mike, you point out that 6 of the top 10 performing stocks in the S&P 100 over the last decade are technology-oriented. But this proves nothing. Higher-risk stocks will always congregate at the top -- and at the bottom -- of any performance list. For example, in any given week, the highest-paying racehorses will all be the long shots, even though it has been well established that betting the long shots is the worst strategy you can pursue at the races.

Finally, you claim that "there is no growth trap." If that's true, why have "value" stocks trounced "growth" stocks in virtually all long-term studies? Why has the shrinking energy sector outperformed the expanding tech sector since the inception of the S&P 500 index? Why are small-capitalization growth stocks the worst-performing sector of the market? Why have IPOs, whose value depends almost entirely on future growth, badly underperformed the market? And why has the fastest-growing country over the last decade, China, given investors the worst returns?

There most certainly is a growth trap. The real issue, as I make clear in The Future for Investors, is to avoid overpriced stocks, whatever sector they are in. Successful investing requires knowing not only how fast a company will grow but also the price you are paying for that growth. For most of the new companies in the high-tech sectors, the price is too high.

Mandel comes back:

Professor Siegel, I certainly agree with your main point, that the real issue is to avoid overpriced stocks.And I will also cheerfully admit that your new book is filled with good advice and insight for investors, and well worth the price.

However,I continue to find the treatment of tech stocks to be misleading. The main reason is that I define a "technology" sector and a "growth" sector differently from the way you do. To me, a "technology" sector is one in whichinnovation and new technologies are a major source of growth. A "growth" sector is one that is producing an increasing share of economic output.

By this definition, health care is both a technology and a growth sector, and has been for decades.Info tech is a technology sector -- but sometimes it's a growth sector, and sometimes it isn't. For example, from 1984 to 1991,business spending on info-tech equipment and software grew only slightly faster than the economy as a whole. During that period, info tech wasn't a growth sector.And telecom is a technology sector, but it hasn't been a growth sector for decades. Business spending on communications equipment is no higher today, as a share of GDP, than it was in 1980.

That suggests the real problem occurs when investors put money into a tech sector, assuming that a new technology means the sector is accounting for a rising share of the economy as well. If that assumption is borne out -- as in the case of health care -- then the investors appear to have made good decisions. If that assumption doesn't work out -- as in the case of telecom and info tech in the late 1990s -- then investors look excessively optimistic.

One more thing: You note that the technology sector -- info-tech stocks, mainly -- has trailed the market over the past 20 years. That's certainly true -- but what you're not drawing attention to is that, in 1984, the starting point for the 20 years, the bundle of stocks in the tech index that you're citing doesn't include eventual big winners such as Compaq, Computer Associates (CA), Oracle (ORCL), Microsoft, Dell, Cisco, or Sun (SUNW). In fact, oddly enough, Microsoft wasn't added to the index until 1994, and Dell was left out until 1996.

The moral of this story might very well be that, in a fast-changing industry, it isn't smart to buy the old companies at a time when their profits are being eaten away by new companies. In other words, the new beats the old.

To be continued...


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