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Robert Abbott
Robert Abbott
Articles (502)  | Author's Website |

Jeremy Siegel: Stock Characteristics That Offer an Advantage

Do some characteristics offer an enduring strategy that investors can stick with in the long run?

January 08, 2019 | About:

To lead off chapter 12 of “Stocks for the Long-Run,” author Jeremy Siegel challenged his readers: In the year 1950 you had $1,000 to invest, and a choice of two stocks: IBM (NYSE:IBM) or Standard Oil of New Jersey, which is now ExxonMobil (NYSE:XOM). After you made your choice, the stock certificates would be locked in a vault for 62 years, until 2012. Based on hindsight, which company would you choose?

Siegel provided the following table to show growth, valuation and return measures:

Compare IBM and ExxonMobil

Over those 62 years, IBM outshone ExxonMobil in growth. In fact, the computer company was part of the exploding tech stock revolution while the oil company was in an industry that shrank by about half. So, IBM seemed the obvious candidate. Yet Standard Oil proved a better deal for investors: $1,000 invested in Standard Oil was worth $1,620,000 in 2012, more than double what IBM would have been worth.

The difference? Siegel reviewed the factors that might explain these and similar results.

Capitalization

Siegel explained that, historically, small-cap stocks had outperformed large stocks between 1926 and 2012, but there was a potentially misleading factor in that generalization. Between 1975 and the end of 1983, small stocks took off and averaged compound annual returns of 35.3%, which was far better than the large caps of that period. But, in 1984 and for the following 16 years, large caps again took the lead. This Siegel chart shows the results:

Compare large caps small caps

Quite simply, small caps do not necessarily provide better returns, and have lagged their larger counterparts in most periods since 1926. The point, then, is that company size, by capitalization, is not a reliable barometer of stock outperformance.

Value vs. growth stocks

The author wrote, “Stocks whose prices are low relative to these fundamentals are called value stocks, while those with prices high relative to firm fundamentals are called growth stocks.” The fundamentals to which he refers include dividends, earnings, book values and cash flows. Siegel did not offer an opinion in this section about which type would be better, but he did later in the chapter.

Dividend yields

Dividends have long been an important key in stock selection; as Graham and Dodd wrote in 1940, “Experience would confirm the established verdict of the stock market that a dollar of earnings is worth more to the stockholder if paid him in dividends than when carried to surplus.” Siegel reported that this claim had been supported by other research in the years since 1940.

Siegel himself did research that involved sorting S&P 500 companies into five quintiles, from the lowest dividend yields to the highest yields. This sorting was done on the last day of each year between 1957 and 2011, and then he calculated total returns during the next calendar year. The results are shown in this chart:

High dividend yields high returns

As the chart shows, the higher the dividend yield at one year-end, the higher the return at the end of the following year. An investor who invested in the 100 highest-yielding stocks would get an average pop of 2.5%. As a bonus, the higher the yield, the lower the volatility (as measured by beta) and vice versa.

Price-earnings ratio

Again, the author cites Graham and Dodd, this time in their 1934 classic “Security Analysis” where they wrote, “Hence we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 16 times their average earnings are likely to lose considerable money in the long run.”

Siegel followed up with research of his own, which paralleled that he did for dividend yields. In this case, he sorted stocks from the S&P 500 into five quintiles, from lowest price-earnings to highest price-earnings at year-end and then calculated their total returns in the following 12 months. As value investors would expect, stocks with high price-earnings returned less than stocks with low price-earnings. The highest price-earnings stocks returned an average of 7.86%, which was handily outperformed by the lowest price-earnings stocks, which averaged 12.92%.

Size and valuation criteria combined

Again, Siegel has done research of his own, including the results of combining stock size and valuation criteria. He came to this conclusion, “Historical returns on value stocks have surpassed the returns on growth stocks, and this outperformance is especially true among smaller stocks. The smallest value stocks returned 17.73 percent per year, the highest of any of the 25 quintiles analyzed, while the smallest growth stocks returned only 4.70 percent, the lowest of any quintile.”

The following chart and table tell the tale:

Growth stocks vs value stocks

To the remark above, he added that as a firm becomes larger, differences between returns for value and growth stocks diminishes; still, there is a sizable difference.

Initial publish offerings (IPOs)

The author told readers there is often excitement about new public offerings and that can cause them to surge in price after being released. Some prominent companies, such as Walmart (NYSE:WMT) and Home Depot (NYSE:HD), have made the investors who bought and held their initial offerings quite wealthy. But, as Siegel asked, can the big winners win by enough to make up for the losers?

The answer is “no.” In examining the results of IPOs between 1968 and the end of 2003, he looked at 8,606 of them and found that 6,796 (79%) had underperformed the returns of a representative small stock index. What’s more, almost half underperformed by at least 10% per year.

What’s in a name?

Siegel pointed out that the “growth” and “value” designations are not inherent. Instead, the names depend on the relationship between market value and a fundamental measure of the firm’s value, measures such as earnings or dividends.

And, as circumstances change, the designations too may change. For example, once-hot tech stocks with high growth prospects could switch from “growth” to “value” if they grow out of favor with investors and their stock prices are depressed compared to their fundamentals. The same can happen with “value” stocks that suddenly get a lot of love from the market and become “growth” stocks.

Liquidity

In recent years, yet another factor has been found that can help explain returns. This is liquidity, which is the discount that sellers would face if they had to sell on short notice. Thus, assets with high liquidity have low discounts and vice versa. It can be measured by the ratio of average daily volume compared with the total number of shares outstanding, which is called “turnover.”

Siegel concluded the chapter with these words:

“Over time, portfolios of stocks with higher dividend yields, lower P/E ratios, and lower liquidity have outperformed the market more than would be predicted by the efficient market hypothesis.

“Nevertheless, investors should be aware that no strategy will outperform the market all the time. Small stocks exhibit periodic surges that have enabled their long-term performance to beat that of large stocks, but most of the time their performance has only matched or fallen behind that of large stocks. Furthermore, value stocks have generally done well in bear markets, although in the last recession, value stocks, because of the high preponderance of financials, underperformed growth stocks. This means that investors must exercise patience if they decide to pursue these return-enhancing strategies.”

The answer to the question posed in the sub-headline above, then, is that there is no enduring strategy for stocks in the long run, but higher dividend yields, lower price-earnings ratios and lower liquidity will help in most periods.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website


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