Dr. Jeremy J. Siegel: The Future for Investors

Award-Winning Russell J. Palmer Professor
of Finance delivers Alumni Weekend
lecture based on new book to capacity audience
Rationale for best returns in stocks

This a summary of Professor Siegel’s comments drawn from the lecture and his latest book, The Future for Investors Why the Tried and True Triumphs over the Bold and New. This follows his earlier bestseller, Stocks for the Long Run.

These notes are courtesy of Fred Wolgel, Esq., WG’85, President of the Wharton Club of Houston. We greatly appreciate Fred's help in sharing with us the essence of Dr. Siegel's remarks delivered recently to a capacity audience in Philadelphia.


The Verdict of History

In the late 1980’s and early 90’s, Prof. Siegel did his research on real returns, i.e. returns measured after taking inflation into account. A dollar invested in stocks in 1801 would be $649,000 today; gold had almost a zero return. A dollar would be 6 cents, a 94% decline in value. Bonds went to $1090, and Treasury bills went to $294.

The asset class of stocks has the greatest volatility in the short run, but in the long run has remarkable consistency. He draws a trend line. When you are above the trend line, you are at risk to revert to the trend line. The best returns are when you are under the trend line. Today we are 5% under the trend line, so now is a good time to be in stocks.

He looked at annual stock market returns, after inflation, with dividends reinvested. From 1802 to 2004, the average annual return after inflation, on a diversified basket of stocks is 6.8%. That means on average your portfolio will double every ten years. The worst negative period was 1966-1981, down .4%. He calls it “mean reversion of equity returns” – volatile in short run, mean reverting in the long run. There are some pretty long periods of time when you are not between 6.5 and 7%.

The 80’s and 90’s were the greatest bull market of the past 200 years. From 1982-1999, returns averaged 13.6%/year, almost double the long run average. If you go from 1984-2004, it was 9.3%.

Bond returns for the same 200+ year period of 1802 – 2004 was 3.5%. Since the end of World War II, the average real return from 1946 to 2004 has been 1.5%. Bonds have been 7.2% for 1984-2004, meaning bonds are a very bad bet for the near term, as they are above the trend line.

The risk (volatility) of stocks is 18% in one year, about 9% for stocks and 6% for Treasury bills. But if your holding period increases, the risk profile changes remarkably. By ten years stocks are only slightly higher than bonds, and by 20 years bonds are riskier than stocks, and by 30 years the gap is even wider (though still not very large).

TIPPS (inflation protected) bonds have zero risk, but they only give you 1.6% return over inflation.

Professor Siegel’s New Book, The Future for Investors:
Why the Tried and True Triumphs over the Bold and New

Two questions that he repeatedly got over the years: 1. which stocks for the long run? The easy answer: index your portfolio.

The second question: 2. what happens when all the baby boomers retire and sell all their stocks?

On the first question, which stocks, he looked at 50 years of data for individual stocks. Suppose on Sept 1 1950, you had to pick between two stocks: Standard Oil of New Jersey, and IBM. What will it look like 50 years later? In 1950 it was before IBM had its huge growth, as they hadn’t started into computers.

Growth measures: Revenue. Who did better? IBM, 12.46%/year versus 8.35% year for Standard Oil.

EPS: 11.39% for IBM versus 7.01% for Standard Oil.

Market value: 12.17% IBM, 9.37% Standard Oil.

So which had the best return? The winner is Standard Oil of New Jersey (now ExxonMobil). IBM wins every category EXCEPT the one that matters most: on valuation, the stock price. On average PE ratio, IBM’s PE ratio is 26.92 and Standard Oil has a 12.81 PE ratio. On average dividend yield, IBM is 2.24% and Standard Oil is 5.01%. So Standard Oil is the big winner.

Through dividends and reinvestment of dividends in additional shares, one would have accumulated 15 times the number of original shares of Standard Oil, while one would have accumulated only 3 times the number of original shares of IBM. So even though the market value of IBM went up faster, the individual shareholder did better with Standard Oil, because he now owned more shares.

The top performing companies were, in order of annual returns are: 1. Kraft 15.47% annual return; 2. Reynolds Tobacco 15.16%, 3. Standard Oil 14.42%, 4. Coca Cola 14.33%.

All of these companies are doing the same thing now that they were doing fifty years ago. All of them have more than 50% of their sales outside the U.S.

How do these returns compare to the total market? Total Market return: 11.42% (I think this is before inflation, i.e. nominal, not real return).

Notice also these companies do business in the addictive “C’s”: Calories, Cigarettes, Cars, Caffeine and Cocaine. One of the original ingredients of coca cola was cocaine, but of course they took that out very early on. It still has caffeine as an ingredient.

What happened to the ORIGINAL S&P 500 originally formulated in 1957?

The S&P adds about 20 companies a year (they have to because of mergers, companies going out of business, etc). Cites a book called Creative Destruction by Richard Foster and Sara Kaplan from McKinsey in 2001. “New companies generate higher levels of total return to shareholders than do the older survivors. For example if the S&P 500 were today made up of only those companies that were on the list when it was formed in 1957, the overall performance would have been significantly less.”

Jeremy Siegel got a bunch of students to look at the data. He took the original 500 companies and traced what happened to them and their return. What if you bought those 500 companies and held onto them for 50 years, always reinvesting the dividends. How many of the original 500 stayed the same (maybe a different name but still the same) – 125. Plus merged firms (92) plus companies that went private and then reissued from privatization (11), which what he calls the Direct Descendants Portfolio = 228. That number plus 111 Spin-offs, which he calls Total Descendants Portfolio = 339.

He uses as a benchmark the S&P 500 (not the original S&P 500, but the evolved S&P 500). This has a return of 10.85%. Compare that to: The Total Descendants = 11.40% return, Direct Descendants = 11.35% and Survivors Portfolio = 11.31%.

This is from 1957 – 2003. He says Kaplan and Foster confused Return and Market Value. You have to look at the effect of reinvesting the dividends.

Also, new stocks that enter the S&P 500 are often overvalued.

He reviews the twenty best performing survivors of the original S&P 500. Number 1 is Phillip Morris, 2 is Abbott Labs, 3 is Bristol Myers Squibb, and 4 is Tootsie Rolls! The top 20 average is 15.26%, versus 10.85% for the S&P 500.

Average PE ratio of these companies is 19.04 versus S&P 500 PE ratio of 17.35%.

Note that the average dividend yield is 3.40%, so they return cash to shareholders.

Is there a “Corporate El Dorado”?

He defines El Dorado as the golden company that continually performs better than the markets. The McKinsey consultants say that is a myth, no such company exists. Siegel says if you look at every stock traded from 1925, the best performing stock is Phillip Morris. If you look at the best performing stock since 1950, it is Philip Morris. What is best stock since 1957? Philip Morris. If you put $1,000 in the S&P 500 in 1957, it would be $124,522 by the end of last year. If you had put that same $1,000 in Philip Morris, it would be worth $4.6 million.

Philip Morris has paid $125 billion to litigants for cigarette liability. And they still have outperformed the rest of the market.

The word DIVIDEND is very very important. If you sort by dividend yield, and put your money in the low dividend payers, your money grew to $64,000, if you went to the top 20% dividend yielders, it grew to $462,750. Reinvested dividends is the magic behind extraordinary returns.


Over the last fifty years, two important trends:
--1. Ever-increasing life expectancy and
--2. Ever decreasing retirement age.

In 1950, the average gap between retirement age and life expectancy was only 1.6 years! Now it has widened to 14.4 years!

The number of workers per retiree is the key number. Right now it is 4 or 5 to 1, but it will rapidly decline after 2010, by 2030 it will be 2 to 1 (or less).

This problem is even more severe for Japan and Europe.

This poses major questions: WHO WILL PRODUCE THE GOODS?

The flip side of this question: are there enough wage earners to buy the assets of the baby boomers? WHO WILL BUY THE ASSETS? To absorb the trillions of assets that will be sold into the world economy?

He says the retirement age must rise to 73.

Productivity Growth and Retirement

Is it possible that faster productivity can help with the aging problem. Let us be extraordinarily optimistic and assume future productivity growth averages 3.5% per year, 70% above the long term average of 2.2%.

Even if productivity growth went to 3.5%, it would only reduce the retirement age by 2-3 years. This is because at retirement, people want 85% or so of what they were making at retirement. So productivity growth only helps a little bit.

Immigration Impact

What about immigration? Let’s increase immigration. How many would we have to bring into the U.S. to keep the retirement age at 63? You would need to bring in a half-billion immigrants! This is far in excess of the current population. And you’d have to kick them out at 65! That won’t work.

But there is hope: Look at India. The age profile of many developing countries is the same as the rich companies 50 years ago.

Today, US, Japan and Europe produce three quarters of the world’s GNP. That will change he says.

The Global Solution

The developing countries will own most of the world’s assets and capital. The Developed Economies will run increasing trade deficits.

He doesn’t seem to see this as a bad thing. Compares it to Florida. In fifty years the US will look like Florida. Florida is full of old people, but the other 49 states buy their assets. Now the developing countries will step into the role currently taken by the other 49 states, as the whole United States will start looking like Florida.


` The Core of the portfolio should be indexed to the whole market. 1. Focus on Dividends – sustainable cash flows. 2. International – 40% should be in International stocks, for example, indexed international funds.

Go with High Dividend companies, low price relative to growth, and sectors should be Consumer Staples, Energy, and Health Care. (for the “V’ = Value)

--He is not a pessimist! Growth in the rest of the world will offset slowing in aging economies. •
--Stocks in the low to middle range of Fair Market Value. •
--Forward looking real returns 5.5% to 6%, about one percent below long term historical average. •
--These returns are far above what can be expected in bonds or even real estate. •
--By the middle of this century, China and India will have a bigger economy than all of North America, Europe and Japan COMBINED. •
--Chapter 15 explains how critical communication has been. He thinks we are on the verge of the fastest productivity growth. •
--On real estate, we are at the top of the acceleration curve. Historically, we are at the top. Real returns looking forward will have to be substantially lower. •
--The three major asset classes are stocks, bonds and real estate, and he firmly believes that stocks will outperform bonds and real estate.


About Fred Wolgel, Esq.

Fred Wolgel (WEMBA/WG '85) serves as president of the Wharton Club of Houston. Currently, Fred is a senior counsel in the Enron Estate, where he joined after the bankruptcy for the purpose of liquidating Enron's North American assets.

Previously, he was a senior executive at a company that provided outsourced engineering, operations & maintenance and related services to municipalities regarding their water and wastewater infrastructure. He was responsible for corporate development (M&A and divestitures) and occasional special projects such as leading the effort to bid on a major design/build/operate concession.

Prior to that, he was at the Williams Companies, where he managed the integration of acquisitions for the telecom company and also served in a variety of roles at the gas pipeline subsidiary and with the corporate parent in Tulsa.

Fred began his career as a commercial and regulatory attorney, initially at the Department of Energy and later with the Federal Energy Regulatory Commission. He is a member of the Bars of Texas, the District of Columbia, and Virginia. In addition to Wharton, Fred holds a B.A. from the University of Michigan, and a J.D. from Georgetown.

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