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MAY 4, 2005

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High Prices, Unhappy Returns
The fastest-growing companies don't provide the best rewards, says Jeremy Siegel, for the simple reason that investors overpay


Editor's Note: This exchange between between BusinessWeek Chief Economist Michael J. Mandel and author Jeremy J. Siegel began when, in reviewing Siegel's book, The Future for Investors: Why the Tried and the True Triumphs Over the Bold and the New, Mandel gave mostly praise but took issue with Siegel's belief in valuing old, reliable investments over newfangled ones (see BW Online, 2/14/05, "Forget the Next Big Thing").


That spurred a set of point-counterpoint exchanges: "Debating the 'Growth Trap'", "How to Pick the Tech Winners?", and "No Quarter in this Telecom Tussle". Here's Siegel's latest installment in the ongoing debate. A response from Mandel is attached at the end of this article.

___________________________


Michael, you say that telecom was not a growth sector over the past 10 years. But telecom was certainly viewed that way in 2000, at the height of the Internet craze. In fact, during the late 1990s, real capital expenditures in the telecom industry soared to satisfy what was thought to be "unlimited demand" for bandwidth. Much of the capital was financed by telecom firms floating bonds that triggered the largest bankruptcies in history.

You also say a sector that is growing as a share of the economy will more often than not lead to good stock performance. I would agree with that point if, and only if, investors are not overpaying for that growth. The problem is that too often they do overpay.

HEART OF THE DEBATE.  One would think that the fastest-growing firms would be the best bets for investors. But the evidence says otherwise. If the research presented in my book did not convince you, perhaps this analysis I recently conducted will.

For every December, from 1967 onward, I sorted into quintiles all the S&P 500 firms, based on their sales growth over the previous five years. This analysis gets to the heart of our debate. Do the firms that grew the fastest over the previous five years perform better than the market? And what about the slowest-growing firms? (For every year, I took the fastest-growing firms over the previous five years and calculated their return in the next year.)

The evidence is clear. Over the past nearly 40 years, the fastest-growing firms had the worst subsequent returns: 9.36% per year, vs. 10.7% for the S&P 500 index. And the slowest-growing had the best returns, at 13% per year. The fastest growers didn't perform poorly because they stopped growing quickly. In fact, the fastest-growing stocks continued their above-average growth over the next five years. But investors paid way too high a price for the growth, and returns were poor.

"NECESSARY INGREDIENT."  As far as telecom stocks are concerned, they may have been beaten up enough to yield good future returns. As I mentioned earlier, many telecom stocks have attractive dividend yields. This is precisely what happened to the railroad stocks in the 1950s. With the price low enough, almost any firm becomes a winner.

The principal message of The Future for Investors is that one will not become a good investor by looking at growth alone. A reasonable price is a necessary ingredient to turn a fast-growing firm into a good-returning stock.
___________________________


Mandel responds:

Jeremy, thanks for taking up my challenge. I'm impressed with your new calculation -- that businesses with strong revenue growth have tended to underperform the market, while companies with slow revenue growth have tended to outperform the market -- by a lot. Now, I don't have as encyclopedic knowledge of stock-market literature as you do, but I don't remember seeing this result anywhere else. If true, it seems that you have come up with a simple new guideline for investors: Buy stocks with slow five-year revenue growth.

I note, however, that you agree that telecom stocks may be a good investment right now, although your reasons are not the same as mine. We'll see if the market agrees as well. Don't relax, though -- I'll be back next week with some pointed questions about the second half of your book.



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