3 Lessons From the Original S&P's Top Performers

According to Jeremy Siegel's book The Future for Investors, a portfolio made up of the original companies in the S&P 500 would have outperformed one that followed the changes to the index between its founding in 1957 and 2003. However, what's more surprising is that 11 of the 20 top-performing survivors were big-brand consumer staples and that an investment in any one of the top-performing companies would have crushed the market.

I've listed the surviving top consumer staples and their annual return during the time period Siegel studied. The board has changed a little since Siegel conducted his research. Wrigley has become a part of Mars, and Fortune Brands has split into Beam and Fortune Brands Home & Security.

Company

Annual Return 1957-2003

Altria (NYSE: MO  ) 19.75%
Tootsie Roll Industries (NYSE: TR  ) 16.11%
Coca-Cola (NYSE: KO  ) 16.02%
PepsiCo (NYSE: PEP  ) 15.54%
Colgate-Palmolive (NYSE: CL  ) 15.22%
H.J. Heinz 14.78%
Wrigley 14.65%
Fortune Brands 14.55%
Procter & Gamble (NYSE: PG  ) 14.26%
Hershey Foods (NYSE: HSY  ) 14.22%
General Mills 13.58%
   
S&P 500 10.85%

Source: The Future for Investors.

I'm not recommending that you should go out and buy these stocks right now -- although they certainly deserve a place on your watchlist. Past performance is no guarantee of future returns, but you can learn valuable lessons from figuring out what made these companies perform so well.

Lesson 1: Moats matter.
The sustainable competitive advantage -- or moat -- is the foundation of a stock built for the long run. These companies benefit from two of the most important: intangible assets, and cost advantages. In this case, by intangible assets I mean brand names -- specifically, brand names that lead consumers to spend more than they would otherwise. For example, Altria manufactures Marlboro cigarettes, which held 42.6% of the U.S. cigarette market in 2010. Marlboro's volumes slipped a little recently, but Its share is larger than the next 13 brands combined. The brand is so strong that its market share tops the combined offerings from competitors Reynolds American and Lorillard. In the United States, "cigarette" might as well mean "Marlboro."

Procter & Gamble has a similar advantage with Tide. At the core, there isn't much difference between Tide and any other laundry detergent, but P&G has managed to convince most of us that it's worth paying a little more for the orange bottle with a blue cap.

The company also benefits from cost advantages. When you walk down the detergent aisle, you'll find the original Tide formula next to the cold-water version and high-efficiency formula, along with a variety of scents and their corresponding cold-water and high-efficiency formulations. This variation essentially creates a Tide billboard in the middle of the grocery store. Because P&G is so large, adding another variety of detergent is relatively cheap when compared with what a smaller competitor would have to spend to create a similar billboard.

Lesson 2: It takes more than great earnings to generate returns.
Let's be honest: Consumer staples isn't that exciting of a sector. We can't speculate about how the latest flavor of toothpaste will spark growth in the same way we can the latest tablet or smartphone OS. As a result, investors don't expect much growth -- which is exactly why they have performed so well.

As Siegel states in The Future for Investors, "long-term return on a stock depends not on the actual growth of its earnings but on how those earnings compare to what investors expected." When investors expect a company's earnings to grow quickly, they will pay more for it. Unfortunately, this can be a mistake. According to Siegel, portfolios invested in high-P/E stocks lagged the S&P 500 by 2% a year. Meanwhile, portfolios made up of the lowest-P/E stocks in the index beat the market by 3% a year.

Lesson 3: Dividends are like steroids for stock returns.
A reasonably priced or cheap company becomes an even better deal when it also pays a dividend. By reinvesting that generous dividend yield, investors can supersize their returns. For example, let's look at the difference dividend reinvestment made to Altria and Coca-Cola's returns over the past 30 years.

Company

Return Without Reinvestment

Annualized

Return With Reinvestment

Annualized

Altria 1,140.9% 8.8% 21,092.3% 19.5%
Coca-Cola 4,394.7% 13.5% 9,388.8% 16.4%

Source: Yahoo! Finance.

The truth is, over the long term, reinvesting dividends leads to the greatest returns. The top-performing stocks all pay generous dividends, which their economic moats have helped maintain. This situation allows the patient shareholder to use dividend payments to steadily acquire more shares and take advantage of the power of compounding interest to slowly build wealth. As a bonus, temporary dips in the stock price can actually help long-term investors, because they can increase the purchasing power of the dividend payments if they align with the dips.

The Foolish takeaway
So in short, if you're looking for an investment built for long-term gains, you want to look for a company with a wide, sustainable moat that pays a steady dividend and buy it at a reasonable or cheap valuation. I'm not saying this is the only strategy for generating huge returns, but time has proved that that it works remarkably well.

If you'd like more ideas for taking advantage of the power of dividends, then you should check out the special report "Secure Your Future With 11 Rock-Solid Dividend Stocks." The report is absolutely free, so download it today!

The Motley Fool owns shares of Altria Group, Coca-Cola, and PepsiCo. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Procter & Gamble, H.J. Heinz, PepsiCo, and Beam, creating a diagonal call position in PepsiCo, and creating a bear put ladder position in Lorillard. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Patrick Martin owns shares of Altria and Reynolds American. You can follow him on Twitter, where he goes by @TMFpcmart03. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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