The Growth Trap

(Zen Buddha Silence by Marilyn Barbone)

(Image:  Zen Buddha Silence by Marilyn Barbone.)

September 25, 2016

Jeremy Siegel is the author of The Future for Investors (Crown Business, 2005).  Warren Buffett commented:  “Jeremy Siegel’s new facts and ideas should be studied by investors.”  (Although the book was published in 2005, most of the facts and ideas still hold.)

 

INTRODUCTION

Siegel summarizes the main lesson from his previous book, Stocks for the Long Run:

My research showed that over extended periods of time, stock returns not only dominate the returns on fixed-income assets, but they do so with lower risk when inflation is taken into account.  These findings established that stocks should be the cornerstone of all long-term investors’ portfolios.

As you extend forward in time, especially to three or four decades, the real return from stocks is roughly 6.5 to 7 percent, which will nearly always be better than any other investment, such as fixed-income or gold.  Siegel has given many talks on Stocks for the Long Run, and he reports that two questions always come up:

  • Which stocks should I hold for the long run?
  • What will happen to my portfolio when the baby boomers retire and begin liquidating their portfolios?

Siegel says he wrote The Future for Investors in order to answer these questions.  He studied all 500 firms that constituted the S&P 500 Index when it was first formulated in 1957.  His conclusions – that the original firms in the index outperformed the newcomers (those added later to the index) – were surprising:

These results confirmed my feeling that investors overprice new stocks, many of which are in high technology industries, and ignore firms in less exciting industries that often provide investors superior returns.  I coined the term the growth trap to describe the incorrect belief that the companies that lead in technological innovation and spearhead economic growth bring investors superior returns.

The more I investigated returns, the more I determined that the growth trap affected not just individual stocks, but also entire sectors of the market and even countries.  The fastest-growing new firms, industries, and even foreign countries often suffered the worst return.  I formulated the basic principle of investor return, which specifies that growth alone does not yield good returns, but only growth in excess of the often overly optimistic estimates that investors have built into the price of stock.  It was clear that the growth trap was one of the most important barriers between investors and investment success.  (page xii, my emphasis)

As regards the aging of the baby-boom generation, Siegel argues that growth in developing countries (like China and India) will keep the global economy moving forward.  Also, as citizens in developing countries become wealthier, they will buy assets that baby-boomers are selling.  Siegel also holds that information technology will be central to global economic growth.

I am not going to discuss baby-boomer retirement any further in this blog post.  I would only note that there is a good chance that economically significant innovation could surprise on the upside in the next few decades.  See, for instance, The Second Machine Age, by Erik Brynjolfsson and Andrew McAfee (W. W. Norton, 2016).  As Warren Buffett has frequently observed, the luckiest people in history are those being born now.  Life in the future for most people is going to be far better than at any previous time in history.

 

THE GROWTH TRAP

Siegel opens the first chapter by noting the potential impact of improving technology:

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.

Yet investors must be careful to avoid 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.  (page 3, my emphasis)

Although technology has created amazing wealth and well-being, investing in new technologies is generally a poor investment strategy.  Siegel explains:

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.  (page 5)

To illustrate his point, Siegel compares Standard Oil of New Jersey (now ExxonMobil) with the new-economy juggernaut, IBM.  Consider the growth rates of these companies from 1950 to 2003:

 

Growth Measures IBM Standard Oil Advantage
Revenue/Share 12.19% 8.04% IBM
Dividends/Share 9.19% 7.11% IBM
Earnings/Share 10.94% 7.47% IBM
Sector Growth 14.65% -14.22% IBM

 

IBM performed much better fundamentally than Standard Oil of New Jersey.  Moreover, from 1950 to 2003, the technology sector rose from 3 percent of the market to almost 18 percent, while oil stocks shrank from 20 percent of the market to 5 percent.  Therefore, it seems clear that an investor who had to choose between IBM and Standard Oil in 1950 should have chosen IBM.  But this would have been the wrong decision.

Over the entire period, Standard Oil of New Jersey had an average P/E of 12.97, while IBM had an average P/E of 26.76.  Also, Standard Oil had an average dividend yield of 5.19%, while IBM had an average dividend yield of 2.18%.  As a result, the total returns for the two stocks were as follows:

 

Return  Measures IBM Standard Oil Advantage
Price Appreciation 11.41% 8.77% IBM
Dividend Return 2.18% 5.19% Standard Oil
Total Return 13.83% 14.42% Standard Oil

 

Siegel explains:

IBM did very well, but investors expected it to do well, and its stock price was consistently high.  Investors in Standard Oil had very modest expectations for earnings growth and kept the price of its shares low, allowing investors to accumulate more shares through the reinvestment of dividends.  The extra shares proved to be Standard Oil’s margin of victory.  (page 9)

Here are Siegel’s broad conclusions on the S&P 500 Index:

  • The more than 900 new firms that have been added to the index since it was formulated in 1957 have, on average, underperformed the original 500 firms in the index.
  • Long-term investors would have been better off had they bought the original S&P 500 firms in 1957 and never bought any new firms added to the index. By following this buy-and-never-sell approach, investors would have outperformed almost all mutual funds and money managers over the last half century.
  • Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run… Portfolios invested in the highest-yielding stocks returned 3 percent per year more than the S&P 500 Index, while those in the lowest-yielding stocks lagged the market by almost 2 percent per year.
  • The return on stocks depends not on earnings growth but solely on whether this earnings growth exceeds what investors expected, and those growth expectations are embodied in the price-to-earnings, or P/E ratio. Portfolios invested in the lowest-P/E stocks in the S&P 500 Index returned almost 3 percent per year more than the S&P 500 Index, while those invested in the high-P/E stocks fell 2 percent per year behind the index.
  • The growth trap holds for industry sectors as well as individual firms. The fastest-growing sector, the financials, has underperformed the benchmark S&P 500 Index, while the energy sector, which has shrunk almost 80 percent since 1957, beat this benchmark index.  The lowly railroads, despite shrinking from 21 percent to less than 5 percent of the industrial sector, outperformed the S&P 500 Index over the last half century.
  • The growth trap holds for countries as well. The fastest-growing country over the last decade has rewarded investors with the worst returns.  China, the economic powerhouse of the 1990s, has painfully disappointed investors with its overpriced shares and falling stock prices.

 

THE TRIED AND TRUE

But how, you will ask, does one decide what [stocks are] ‘attractive’?  Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’… We view that as fuzzy thinking… Growth is always a component of value [and] the very term ‘value investing’ is redundant. 

– Warren Buffett, Berkshire Hathaway annual report, 1992

What was the best-performing stock from 1957 to 2003?  Siegel answers that it was Philip Morris.  Siegel observes:

The superb returns in Philip Morris illustrate an extremely important principle of investing:  what counts is not just the growth rate of earnings but the growth of earnings relative to the market’s expectation.  One reason investors had low expectations for Philip Morris’s growth was because of its potential liabilities.  But its growth has continued apace.  The low expectations combined with high growth and a high dividend yield provide the perfect environment for superb investor returns.  (page 35)

What were the top-performing S&P 500 Survivors from 1957 to 2003?

 

Rank 2003 Name Accumulation of $1,000 Annual Return
1 Philip Morris $4,626,402 19.75%
2 Abbott Labs $1,281,335 16.51%
3 Bristol-Myers Squibb $1,209,445 16.36%
4 Tootsie Roll Industries $1,090,955 16.11%
5 Pfizer $1,054,823 16.03%
6 Coca-Cola $1,051,646 16.02%
7 Merck $1,003,410 15.90%
8 PepsiCo $866,068 15.54%
9 Colgate-Palmolive $761,163 15.22%
10 Crane $736,796 15.14%
11 H. J. Heinz $635,988 14.78%
12 Wrigley $603,877 14.65%
13 Fortune Brands $580,025 14.55%
14 Kroger $546,793 14.41%
15 Schering-Plough $537,050 14.36%
16 Proctor & Gamble $513,752 14.26%
17 Hershey Foods $507,001 14.22%
18 Wyeth $461,186 13.99%
19 Royal Dutch Petroleum $398,837 13.64%
20 General Mills $388,425 13.58%
S&P 500 $124,486 10.85%

 

Siegel points out that most of the top twenty performers have strong brands, but are not technology companies per se.  Siegel discusses some of these great companies:

Number four on this list is a most unlikely winner – a small manufacturer originally named the Sweets Company of America.  This company has outperformed the market by 5 percent a year since the index was formulated.  The founder of this firm, an Austrian immigrant, named its product after his five-year-old daughter’s nickname, Tootsie….

The surviving company with the sixth highest return produces a product today with the exact same formula as it did over 100 years ago, much like Tootsie Roll…. Although the company keeps the formula for its drinks secret, it is no secret that Coca-Cola has been one of the best companies you could have owned over the last half century.

…Pepsie also delivered superb returns to its shareholders, coming in at number eight and beating the market by over 4 percent per year.

Two others of the twenty best-performing stocks also manufacture products virtually unchanged over the past 100 years:  the William Wrigley Jr. Company and Hershey Foods.  Wrigley came in at number twelve, beating the market by almost 4 percent per year, whereas Hershey came in at seventeen, beating the market by 3 percent a year.

Wrigley is the largest gum manufacturer in the world, commanding an almost 50 percent share in the global market and selling in approximately 100 countries.  Hershey is currently the number-one U.S.-based publicly traded candy maker (Mars, a private firm, is number one, followed by Swiss-based Nestle).

…Heinz is another strong brand name, one that is virtually synonymous with ketchup.  Each year, Heinz sells 650 million bottles of ketchup and makes 11 billion packets of ketchup and salad dressings – almost two packets for every person on earth.  But Heinz is just not a ketchup producer, and it does not restrict its focus to the United States.  It has the number-one or –two branded business in fifty different countries, with products such as Indonesia’s ABC soy sauce (the second-largest-selling soy sauce in the world) and Honig dry soup, the best-selling soup brand in the Netherlands.

Colgate-Palmolive also makes the list, coming in at number nine.  Colgate’s products include Colgate toothpastes, Speed Stick deoderant, Irish Spring soaps, antibacterial Softsoap, and household cleaning products such as Palmolive and Ajax.

No surprise that Colgate’s rival, Procter & Gamble, makes this list as well, at number sixteen.  Procter & Gamble began as a small, family-operated soap and candle company in Cincinnati, Ohio, in 1837.  Today, P&G sells three hundred products, including Crest, Mr. Clean, Tide, and Tampax, to more than five billion consumers in 140 countries.

…Number twenty on the list is General Mills, another company with strong brands, which include Betty Crocker, introduced in 1921, Wheaties (the ‘Breakfast of Champions’), Cheerios, Lucky Charms, Cinnamon Toast Crunch, Hamburger Helper, and Yoplait yogurt.

What is true about all these firms is that their success came through developing strong brands not only in the United States but all over the world.  A well-respected brand name gives the firm the ability to price its product above the competition and deliver more profits to investors.

…Besides the strong consumer brand firms, the pharmaceuticals had a prominent place on the list of best-performing companies.  It is noteworthy that there were only six health care companies in the original S&P 500 that survive to today in their original corporate form, and all six made it onto the list of best performers.  All of these firms not only sold prescription drugs but also were very successful in marketing brand-name over-the-counter treatments to consumers, very much like the brand-name consumer staples stocks that we have reviewed.

…When these six pharmaceuticals are added to the eleven name-brand consumer firms, seventeen, or 85 percent, of the twenty top-performing firms from the original S&P 500 Index, feature well-known consumer brand names.  (pages 37-41)

 

INVESTOR EXPECTATIONS

What really matters for investors is the price paid today compared to all future free cash flows.  But investors very regularly overvalue high-growth companies and undervalue low-growth or no-growth companies.  This is the key reason value investing works.  As Siegel writes:

Expectations are so important that without even knowing how fast a firm’s earnings actually grow, the data confirm that investors are too optimistic about fast-growing companies and too pessimistic about slow-growing companies.  This is just one more confirmation of the growth trap.  (page 42)

Thus, if you want to do well as an investor, it is best to stick with companies trading at low multiples (low P/E, low P/B, low P/S, etc.).  All of the studies have confirmed this.  See:  http://boolefund.com/the-ugliest-stocks-are-the-best-stocks/

Siegel did his own study, dividing S&P 500 Index companies into P/E quintiles.  From 1957 to 2003, the lowest P/E quintile – bought at the beginning of each year – produced an average annual return of 14.07% (with a risk of 15.92%), while the highest P/E quintile produced an average annual return of 9.17% (with a risk of 19.39%).  The S&P 500 Index averaged 11.18% (with a risk of 17.02%)

If you’re doing buy-and-hold value investing – as Warren Buffett does today – then you can pay a higher price as long as it is still reasonable and as long as the brand is strong enough to persist over time.  Buffett has made it clear, however, that if he were managing a small amount of money, he would focus on micro-cap companies available at cheap prices.  That would generate the highest returns, with 50% per year being possible in micro caps for someone like Buffett.

Siegel discusses GARP, or growth at a reasonable price:

Advocates here compute a very similar statistic called the PEG ratio, or price-to-earnings ratio divided by the growth rate of earnings.  The PEG ratio is essentially the inverse of the ratio that Peter Lynch recommended in his book, assuming you add the dividend yield to the growth rate.  The lower the PEG ratio, the more attractively priced a firm is with respect to its projected earnings growth.  According to Lynch’s criteria, you would be looking for firms with lower PEG ratios, preferably 0.5 or less, but certainly less than 1.  (page 46)

It’s important to note that earnings growth is very mean-reverting.  In other words, most companies that have been growing fast do NOT continue to do so, but tend to slow down quite a bit.  That’s why deep value investing – simply buying the cheapest companies (based on low P/E or low EV/EBIT), which usually have low- or no-growth – tends to produce better returns over time than GARP investing does.  This is most true, on average, when you invest in cheap micro-cap companies.

Deep value micro-cap investing tends to work quite well, especially if you also use the Piotroski F-Score to screen for cheap micro-cap companies that also have improving fundamentals.  This is the approach used by the Boole Microcap Fund.

One other way to do very well investing in micro caps is to try to find the ones that will grow for a long time.  So you’re looking for the future Wal-Mart’s or Microsoft’s.  Ian Cassel at the MicroCapClub – www.microcapclub.com – uses this approach and continues to do well with it.

 

GROWTH IS NOT RETURN

Most investors seem to believe that the fastest-growing industries will yield the best returns.  But this is simply not true.  Siegel compares financials to energy companies:

Of the ten major industries, the financial sector has gained the largest share of market value since the S&P 500 Index was founded in 1957.  Financial firms went from less than 1 percent of the index to over 20 percent in 2003, while the energy sector has shrunk from over 21 percent to less than 6 percent over the same period.  Had you been looking for the fastest-growing sector, you would have sunk your money in financial stocks and sold your oil stocks.

But if you did so, you would have fallen into the growth trap.  Since 1957, the returns on financial stocks have actually fallen behind the S&P 500 Index, while energy stocks have outperformed over the same period.  For the long-term investor, the strategy of seeking out the fastest-growing sector is misguided.  (pages 50-51)

Siegel continues by noting that the GICS (Global Industrial Classification Standard) breaks the U.S. and world economy down into ten sectors:  materials, industrials, energy, utilities, telecommunication services, consumer discretionary, consumer staples, health care, financial, and information technology.  (Recently real estate has been added as an eleventh sector.)

Just as the fastest-growing companies, as a group, underperform the slower growers in terms of investment returns, so new companies underperform the tried and true.  Siegel explains what his data show:

These data confirm my basic thesis:  the underperformance of new firms is not confined to one industry, such as technology, but extends to the entire market.  New firms are overvalued by investors in virtually every sector of the market.  (page 51)

Siegel also answers the question of why energy did so well, despite shrinking from over 21 percent to less than 6 percent of the market:

Why did the energy sector perform so well?  The oil firms concentrated on what they did best:  extracting oil at the cheapest possible price and returning the profits to the shareholders in the form of dividends.  Furthermore investors had low expectations for the growth of energy firms, so these stocks were priced modestly.  The low valuations combined with the high dividends contributed to superior investor returns.  (page 55)

Technology firms have experienced high earnings growth.  Yet investors have tended to expect even higher growth going forward than what subsequently occurs.  Thus we see again that investors systematically overvalue high-growth companies, which leads to returns that trail the S&P 500 Index.  Technology may be the best example of this phenomenon.  Technology companies have grown very fast, but investors have generally expected too much going forward.

The financial sector is another case of high growth but disappointing (or average) returns.  Much of the growth in financials has come from new companies joining the sector and being added to the index.  Siegel:

The tremendous growth in financial products has spurred the growth of many new firms.  This has caused a steady increase in the market share of the financial sector, but competition has kept the returns on financial stocks close to average over the whole period.  (page 58)

To conclude his discussion of the various sectors, Siegel writes:

The data show that three sectors emerge as long-term winners.  They are health care, consumer staples, and energy.  Health care and consumer staples comprise 90 percent of the twenty best-performing surviving fims of the S&P 500 Index.  These two sectors have the highest proportion of firms where management is focused on bringing quality products to the market and expanding brand-name recognition on a global basis.

The energy sector has delivered above-average returns despite experiencing a significant contraction of its market share.  The excellent returns in this sector are a result of two factors:  the relatively low growth expectations of investors (excepting the oil and gas extractors during the late 1970s) and the high level of dividends.  (page 66)

 

TECHNOLOGY: PRODUCTIVITY CREATOR AND VALUE DESTROYER

Siegel opens the chapter by remarking:

Economic growth is not the same as profit growth.  In fact, productivity growth can destroy profits and with it stock values.  (page 102)

Siegel continues:

Any individual or firm through its own effort can rise above the average, but every individual and firm, by definition, cannot.  Similarly, if a single firm implements a productivity-improving strategy that is unavailable to its competition, its profits will rise.  But if all firms have access to the same technology and implement it, then costs and prices will fall and the gains of productivity will go to the consumer.  (page 105)

Siegel notes that Buffett had to deal with this type of issue when he was managing Berkshire Hathaway, a textile manufacturer.  Buffett discussed plans presented to him that would improve workers’ productivity and lower costs:

Each proposal to do so looked like an immediate winner.  Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable investments in our highly profitable candy and newspaper businesses.

Yet Buffett realized that the proposed improvements were available to all textile companies.  Buffett commented in his 1985 annual report:

[T]he promised benefits from these textile investments were illusory.  Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide.  Viewed individually, each company’s investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes).  After each round of investment, all the players had more money in the game and returns remained anemic.

Eventually, after a decade, Buffett realized he had to close the company.  (He had kept it open for a decade out of concern for the employees, and because management was doing an excellent job with the hand it was dealt.)  Siegel comments:

Buffett contrasts his decision to close up shop with that of another textile company that opted to take a different path, Burlington Industries.  Burlington Industries spent approximately $3 billion on capital expenditures to modernize its plants and equipment and improve its productivity in the twenty years following Buffett’s purchase of Berkshire.  Nevertheless, Burlington’s stock returns badly trailed the market.  As Buffett states, ‘This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise.’  (page 106)

Siegel then draws a broader conclusion about technology:

Historical economic data indicate that the fruits of technological change, no matter how great, have ultimately benefited consumers, not the owners of firms.  Productivity lowers the price of goods and raises the real wages of workers.  That is, productivity allows us to buy more with less.

Certainly, technological change has transitory effects on profits.  There is usually a ‘first mover’ advantage.  When one firm incorporates a new technology that has not yet been implemented by others, profits will increase.  But as others avail themselves of this technology, competition ensures that prices will fall and profits will revert to normal.  (page 109)

 

WINNING MANAGEMENTS IN LOSING INDUSTRIES

Siegel quotes Peter Lynch:

As a place to invest, I’ll take a lousy industry over a great industry anytime.  In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market.  A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.

Many investors try to look for an industry with a bright future, and then select a company that will benefit from this growth.  As we’ve already seen, this doesn’t work in general because investors systematically overvalue high-growth companies.

A deep value investment strategy looks for companies at low multiples, with terrible performance.  These companies, as a group, have done much better than the market over time.

Although a deep value approach works well even if it is entirely quantitative – which is what Ben Graham, the father of value investing, often did – it can work even better if you can identify a winning management.  Siegel explains:

… some of the most successful investments of the last thirty years have come from industries whose performances have been utterly horrendous.

These companies have bucked the trend.  They all rose above their competitors by following a simple approach:  maximize productivity and keep costs as low as possible.  (page 113)

Siegel gives Southwest Airlines as an example.  Investors have lost more money in the airline industry than in any other.  But Southwest Airlines established itself as ‘the low-fare airline.’  It accomplished this by being the low-cost airline.  It offered only single-class service, with no assigned seats and no meals.  It only operated city-to-city where demand was high enough.  And it only used Boeing 737’s.  As a result of being the low-cost and low-fare airline, the business performed well and the stock followed.

Siegel also mentions the example of Nucor, which pioneered the use of ‘minimill’ technology and the recycling of scrap steel.  While the steel industry as a whole underperformed the market by close to 4 percent a year for thirty years, Nucor outperformed the market by over 5 percent a year over the same time period.  According to Jim Collins and others, at least 80 percent of Nucor’s success had to do with the leadership and culture of the company.  At Nucor, executives actually received fewer benefits than regular workers:

  • All workers were eligible to receive $2,000 per year for each child for up to four years of postsecondary education, while the executives received no such benefit.
  • Nucor lists all of its employees – more than 9,800 – in its annual report, sorted alphabetically with no distinctions for officer titles.
  • There are no assigned parking spots and no company cars, boats, or planes.
  • All employees of the company receive the same insurance coverage and amount of vacation time.
  • Everybody wears the same green spark-proof jackets and hard hats on the floor (in most integrated mills, different colors designate authority).

Siegel quotes Buffett:

It is the classic example of an incentive program that works.  If I were a blue-collar worker, I would like to work for Nucor.  (page 121)

In stark contrast, Bethlehem Steel had executives using the corporate fleet for personal reasons, like taking children to college or weekend vacations.  Bethlehem also renovated a country club with corporate funds, at which shower priority was determined by executive rank, notes Siegel.

Siegel concludes his discussion of Southwest Airlines and Nucor (and Wal-Mart):

The success of these firms must make investors stop and think.  The best-performing stocks are not in industries that are at the cutting edge of the technological revolution; rather, they are often in industries that are stagnant or in decline.  These firms are headed by managements that find and pursue efficiencies and develop competitive niches that enable them to reach commanding positions no matter what industry they are in.  Firms with these characteristics, which are often undervalued by the market, are the ones that investors should want to buy.  (pages 121-122)

Another great example of a company implementing a low-cost business strategy is 3G Capital, a Brazilian investment firm.  (3G was founded in 2004 by Jorge Paulo Lemann, Carlos Alberto Sicupira, and Marcel Herrmann Telles.)  3G is best known for partnering with Buffett’s Berkshire Hathaway for its acquisitions, including Burger King, Tim Hortons, and Kraft Foods.  When 3G acquires a company, they typically implement deep cost cuts.

 

REINVESTED DIVIDENDS:  THE BEAR MARKET PROTECTOR AND RETURN ACCELERATOR

Siegel explains what can happen to a dividend-paying stock during a bear market:  If the stock price falls more than the dividend, then the higher dividend yield can then be used to reinvest, leading to a higher share count than otherwise.  The Great Depression led to a 25-year period – October 1929 to November 1954 – during which stocks plunged and then took a long time to recover.  Most investors did not do well, often because they could not or did not hold on to their shares.  But investors with dividend-paying stocks who reinvested those dividends did quite well, as Siegel notes:

Instead of just getting back to even in November 1954, stockholders who reinvested their dividends (indicated as ‘total return’) realized an annual rate of return of 6 percent per year, far outstripping those who invested in either long- or short-term government bonds.  In fact, $1,000 invested in stocks at the market peak turned into $4,440 when the Dow finally recovered to its old high on that November day a quarter century later.  Although the price appreciation was zero, the $4,400 that resulted solely from reinvesting dividends was almost twice the accumulation in bonds and four times the accumulation in short-term treasury bills.  (page 140)

Siegel concludes:

There is an important lesson to be taken from this analysis.  Market cycles, although difficult on investors’ psyches, generate wealth for long-term stockholders.  These gains come not through timing the market but through the reinvestment of dividends.

Bear markets are not only painful episodes that investors must endure; they are also an integral reason why investors who reinvest dividends experience sharply higher returns.  Stock returns are generated not by earnings and dividends alone but by the prices that investors pay for these cash flows.  When pessimism grips shareholders, those who stay with dividend-paying stocks are the big winners.  (pages 141-142)

The same logic applies to individual stocks.  If a company is a long-term survivor (or leader), then short-term bad news causing the stock to drop will enhance your long-term returns if you’re reinvesting dividends.  This is also true if you’re dollar-cost averaging.

In theory, share repurchases when the stock is low can work even better than dividends because share repurchases create tax-deferred gains.  In practice, Siegel observes, management is often not as committed to a policy of share repurchases as it is to paying dividends.  Once a dividend is being paid, the market usually views a reduced dividend unfavorably.  Also, shareholders can track dividends more easily than share repurchases.  In sum, when a stock is low, it is usually better for shareholders if they can reinvest dividends instead of relying on management to repurchase shares.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are 15-25 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees.  The Boole Fund has low fees. 

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

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