Chapter One: The Growth Trap
The speculative public is incorrigible. It will buy anything, at any price, if there seems to be some “action” in progress. It will fall for any company identified with “franchising,” computers, electronics, science, technology, or what have you when the particular fashion is raging. Our readers, sensible investors all, are of course above such foolishness. —Benjamin Graham, The Intelligent Investor
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. The pessimists, who proclaim that the retiring baby boomers will bankrupt Social Security, upend our private pension systems, and crash the financial markets, are wrong.
Fundamental demographic and economic forces are rapidly shifting the center of our global economy eastward. Soon the United States, Europe, and Japan will no longer hold center stage. By the middle of this century, the combined economies of China and India will be larger than the developed world’s.
How should you position your portfolio to take advantage of the dramatic changes and opportunities that will appear in the world markets?
To succeed in this rapidly changing environment, investors must grasp a very important and counterintuitive aspect of growth that I call the the growth trap.
The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth—through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries—dooms investors to poor returns. In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.
Ironically, the faster the world changes, the more important it is for investors to heed the lessons of the past. Investors who are alert to the growth trap and learn the principles of successful investing revealed in this book will prosper during the unprecedented changes that will transform the world economy.
The Fruits of Technology
No one can deny the importance of technology. Its development has been the single greatest force in world history. Early advances in agriculture, metallurgy, and transportation spurred the growth of population and the formation of great empires. Throughout history, those who possessed technological superiority, such as steel, warships, gunpowder, airpower, and most recently nuclear weapons, have won the decisive battles that allowed them to rule over vast parts of the earth—or to stop others from doing so.
In time, the impact of technology spread far beyond the military sphere. Technology has allowed economies to produce more with less: more cloth with fewer weavers, more castings with fewer machines, and more food with less land. Technology was at the heart of the Industrial Revolution; it launched the world on a path of sustained productivity growth.
Today, the evidence of that growth is seen everywhere. In the developed world, only a small fraction of work is devoted to securing life’s necessities. Advancing productivity has allowed us to achieve better health, retire earlier, live longer, and enjoy vastly more leisure time. Even in the poorer regions of our globe, advances in technology during the past century have reduced the percentage of the world’s population faced with starvation and those living in extreme poverty.
Indeed, the invention of new technologies has enabled thousands of inventors and entrepreneurs—from Thomas Edison to Bill Gates—to become fabulously wealthy by forming public companies. The corporations that Edison and Gates founded—General Electric and, a century later, Microsoft Corp.—are now ranked number one and two in the world in market value, having a combined capitalization in excess of half a trillion dollars.
Because investors see the enormous wealth of innovators like Bill Gates, they assume they must seek out the new, innovative firms and avoid the older firms that will eventually be upended by advancing technologies. Many of the firms that pioneered automobiles, radio, television, and then the computer and cell phone have not only contributed to economic growth, but also became very profitable. As a result, we set our investment strategies toward acquiring these ground-breaking firms that vanquished the older technologies, naturally assuming our fortunes will increase as these firms profit.
The Growth Trap
But all the assumptions behind these investment strategies prove false. In fact, my research shows that exactly the opposite is true: not only do new firms and new industries fail to deliver good returns for investors, but their returns are often inferior to those of older companies established decades earlier.
Our fixation on growth is a snare, enticing us to place our assets in what we think will be the next big thing. But the most innovative companies are rarely the best place for investors. Technological innovation, which is blindly pursued by so many seeking to “beat the market,” turns out to be a double-edged sword that spurs economic growth while repeatedly disappointing investors.
Who Gains—and Who Loses?
How can this happen? How can these enormous economic gains made possible through the proper application of new technology translate into substantial investment losses? There’s one simple reason: in their enthusiasm to embrace the new, investors invariably pay too high a price for a piece of the action. The concept of growth is so avidly sought after that it lures investors into overpriced stocks in fast-changing and overly competitive industries, where the few big winners cannot begin to compensate for the myriad of losers.
I am not saying there are no gains to be reaped from the creative process. Indeed, there are many who become extremely wealthy from creating the new. If this were not so, there would be no motivation for entrepreneurs to develop pathbreaking technologies nor investors to finance them.
Yet the benefits of all this growth are funneled not to individual investors but instead to the innovators and founders, the venture capitalists who fund the projects, the investment bankers who sell the shares, and ultimately to the consumer, who buys better products at lower prices. The individual investor, seeking a share of the fabulous growth that powers the world economy, inevitably loses out.
History’s Best Long-term Stocks
To illustrate the growth trap, imagine for a moment that we are investors capable of time travel, so we are in the remarkable position of being able to use hindsight to make our investment decisions. Let’s go back to 1950 and take a look at two companies with an eye toward buying the stock of one and holding it to the present day. Let’s choose between an old-economy company, Standard Oil of New Jersey (now ExxonMobil), and a new- economy juggernaut, IBM.
After making your selection and buying the stock, you instruct the firm to reinvest all cash dividends back into its shares, and you put your investment under lock and key. This is an investment that will be opened a half century later, the shares to be sold to fund your grandchild’s education, your favorite charity, or even your own retirement, if you make this choice when you are young.
Which firm should you buy? And why?
The Economy at MidCentury
The first question you might have asked back in 1950 is: which sector of the economy will grow the fastest over the second half of the twentieth century, technology or energy? Fortunately, a quick review of history readily provides the answer. Technology firms were poised for rapid growth.
Not unlike today, the world in 1950 stood at the edge of tremendous change. U.S. manufacturers had shifted from munitions to consumer products, with technology leading the way. In 1948 there were 148,000 television sets in American homes. By 1950 that number had risen to 4.4 million; two years later, the figure was 50 million. The speed of penetration of this new medium was phenomenal and far exceeded that of the personal computer in the 1980s or the Internet in the 1990s.
Innovation was transforming our society, and 1950 was a hallmark year of invention. Papermate developed the first mass-produced, leak-proof ballpoint pen, and Haloid (later renamed Xerox) developed the first copy machine. The financial industry, already a heavy user of technology, was about to take a great leap forward as Diner’s Club introduced the first credit card in 1950. And Bell Telephone Laboratories, a branch of the largest corporation on earth, American Telephone & Telegraph, had just perfected the transistor, a critical milestone that led to the computer revolution.
The future looked so bright that the term “new economy,” so often bandied about during the 1990s technology boom, was also used describe the economy fifty years earlier. Fortune magazine celebrated its twenty-fifth anniversary in 1955 with a special series devoted to “The New Economy” and the remarkable growth of productivity and income that America had achieved since the Great Depression.
IBM or Standard Oil of New Jersey?
Let me give you some other information to help you make your decision. Look at Table 1.1, which compares the vital growth statistics of these two firms. IBM beat Jersey Standard by wide margins in every growth measure that Wall Street uses to pick stocks: sales, earnings, dividends, and sector growth. IBM’s earnings per share, Wall Street’s favorite stock-picking criterion, grew more than four percentage points per year above the oil giant’s growth over the next fifty years. As information technology advanced and computers became far more important to our economy, the technology sector rose from 3 percent of the market to almost 18 percent.table 1.1: annual growth rates, 1950–2003
Growth MeasuresIBMStandard Oil of NJAdvantage
Revenue Per Share12.19%8.04%IBM
Dividends Per Share9.19%7.11%IBM
Earnings Per Share10.94%7.47%IBM
*Change in market share of technology and energy sectors 1957–2003
In contrast, the oil industry’s share of the market shrunk dramatically over this period. Oil stocks comprised about 20 percent of the market value of all US stocks in 1950, but fell to less than 5 percent by year 2000. This shrinkage occurred despite the fact that nuclear power never attained the dominance expected by its advocates and the world continued to be powered by fossil fuels.
If a genie would have whispered these facts in your ear in 1950, would you have placed your money in IBM or Standard Oil of New Jersey?
If you answered IBM, you have fallen victim to the growth trap.
Although both stocks did well, investors in Jersey Standard earned 14.42 percent per year on their shares from 1950 through 2003, more than half a percentage point ahead of IBM’s 13.83 percent annual return. Although this difference is small, when you opened your lockbox fifty-three years later, the $1,000 you invested in the oil giant would be worth over $1,260,000 today, while $1,000 invested in IBM would be worth less than one million dollars, some 25 percent less.
Excerpted from The Future for Investors by Jeremy J. Siegel, author of Stocks for the Long Run. Copyright © 2005 by Jeremy J. Siegel. Excerpted by permission of Crown Business, a division of Random House LLC. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.