One of the biggest misconceptions that inexperienced investors make is to chase hot growth companies. The allure behind many of those companies is that they are in new and exciting industries that offer a lot of potential. New and exciting industries move the world forward and make everyone’s life easier. Unfortunately, investors do not always earn a lot of money this way.
When I first became interested in investing about 15 – 20 years ago, I thought that the way to make money is by investing in hot growth tech companies like Amazon (AMZN), AOL, Yahoo (YHOO), Ebay (EBAY) etc. The problem with this statement is that when you have a new and disruptive industry, you also have a high failure rate of companies in that industry due to the speed of change. For example, today we have all witnessed the success of Amazon and Ebay. However, a lot of companies that were selling at insane valuations in 1999 – 2000 are no longer with us – those include companies like CD Now, The Globe.com, etc. When you have untested growth companies that sell at insane valuations, coupled with a high probability of business failure on those companies, you have a situation where an investor can lose a lot of money, even if they were conceptually right.
Today, we are seeing this with companies like Tesla (TSLA), ShakeShack (SHAK) and Twitter (TWTR). They sell at insane valuations, and will only make money to investors if they do much better than their already rosy projections for the future. Investors seem to have forgotten the importance of pricing and valuation in security selection.
You need to consider the fact that a new concept that will grow might not make investors rich. Did you know that there were approximately 2,000 car companies in the US at the beginning of the 20th century? The automobile changed the way people travel forever. However, investors in those companies did not reap the benefits of the automobile. There were only three surviving companies in the US by the end of the 20th century.
This is because in order to make money with a growth stock, you need to purchase it at an attractive valuation. If you overpay dearly for a company relative to its future growth, you may not earn a return on your investment even if the growth materializes.
This concept has been illustrated by Professor Jeremy Siegel in his book The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New.
He looked at the performance of IBM (IBM) and Standard Oil of New Jersey between 1950 and 2003. Standard Oil of New Jersey is now what we know as Exxon Mobil (XOM). He found that during this period, IBM grew revenue per share by 12.19%/year, dividends per share at 9.19%/year and earnings per share at 10.94%/year.
At the same time, Standard Oil of New Jersey grew revenues per share at 8.04%/year, dividends per share at 7.11%/year and earnings per share at 7.47%/year.
Based on this information, you would think that IBM did much better for investors, right?
In reality, the opposite is the truth. IBM delivered annual total returns of 13.83%/year between 1950 and 2003. Standard Oil of New Jersey returned 14.42%/year during the same time period.
The question is, how can a company with a lower growth end up delivering higher returns than a high growth company in an exciting new industry? After all, IBM was a symbol of the computing era for several decades in the middle of the 20th century.
In order to answer this question, we should look at valuations.
The average P/E ratio on IBM was 26.76. The average dividend yield was 2.18%/year.
The average P/E ratio on Standard Oil of New Jersey was 12.97. The average dividend yield was 5.19%.
You can see that investors in IBM paid too much for future growth. As a result, a large portion of the growth was already discounted in the stock price. In addition, the dividend was very low, because the expectation was for high growth. The share price rose by 11.41%/year, while the dividend yield was 2.18%/year for a total return of 13.83%/year.
With Standard Oil of New Jersey however, the expectations were low to begin with. As a result, the valuation was low as well. This also provided a high dividend yield. The share price rose by 8.77%/year, while the dividend yield was 5.19%/year for a total return of 14.42%/year.
When you combine a scenario where you have consistently low valuation, coupled with a high dividend yield where dividends are reinvested all the time, you are essentially turbocharging investment returns. Dividends represent an important factor in total returns on stocks. When you reinvest dividends at low valuations, this acts as an returns accelerator for the investor.
Since this article is already getting too long, I will share with you the rest of it tomorrow. Please stay tuned.
Full Disclosure: Long IBM and XOM
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