Don't Get Caught in the Growth Trap

While talking about his experience in the stock market, my grandfather once said, "Every time I thought I had it made, I lost it all." Grandpa worked in technology his whole life and never understood why he couldn't parlay his knowledge of the industry into huge market returns. Although I don't know the specifics of his investing career, it seems that he fell into what Wharton professor Jeremy Siegel describes as "the Growth Trap."

Huge growth doesn't guarantee huge returns
In his book The Future for Investors, Siegel defines the growth trap as the tendency for overly excited investors to reduce their future returns by overpaying for companies in growing fields. As an example, he tracks the returns of IBM (NYSE: IBM) and Standard Oil of New Jersey -- which became ExxonMobil (NYSE: XOM) -- from 1950 to 2003. As expected, IBM displayed faster annual growth rates.

Source: The Future for Investors.

However, Siegel found that during the time period, shares of Standard Oil returned 14.42% annually while shares of IBM returned 13.83%. The difference seems small, but an investment of $1,000 made in 1950 in Standard Oil was worth more than $1,260,000 in 2003, while the same investment in IBM was worth $961,000, nearly a quarter less.

Valuation matters
Siegel argues that IBM generated smaller returns because investors expected the company to grow faster and priced it as such. Unfortunately, they overshot it. From 1950 to 2003, it traded at an average P/E of 26.76, almost twice the P/E of Standard Oil, but IBM didn't grow twice as fast. Standard Oil also paid a dividend yield of 5.19%, which was 3 percentage points higher than IBM. As a result, Big Blue produced smaller returns even though it grew faster.

The conclusion Siegel draws is that returns depend not a company's earnings growth, but on how those earnings compare with what investors expected. Investors expected IBM to grow at a faster rate and priced it as such. Investors expected slower growth from Standard Oil and so priced it reasonably, which allowed them to buy shares with their dividends and in time generate greater returns.

To be fair, IBM's returns since 1950 have been quite good. The real danger comes when investors start grossly overpaying for growth -- which is what I think Grandpa did. You can see this happening when P/E ratios in a hot sector rise into the triple digits. Consider Cisco (Nasdaq: CSCO), which at its peak boasted a forward P/E of 131.2. Had you purchased the stock on March 10, 2000 -- the day the Nasdaq peaked -- you would have lost nearly three-quarters of your investment. Meanwhile, the decidedly less exciting consumer-staples giant Procter & Gamble (NYSE: PG) helped investors triple their money.

The hottest stock in the hottest industry
Peter Lynch advises avoiding "the hottest stock in the hottest industry." We almost can't help ourselves. For example, two of the buzziest corners of the tech world these days are cloud computing and social networking. If we look at the hot stocks from both of the industries, we find frighteningly high P/E ratios.

Source: Motley Fool CAPS.

Although it is possible that these two companies could grow at rates that justify their lofty valuations, history suggests that you shouldn't count on it. It's more likely that a bad earnings report will cause investors to flee, or the stocks will simply underperform from here.

A better strategy
Betting on these companies' ability to live up to their lofty valuations is more of a risk than I'm willing to take, especially when there are great tech companies out there trading at more reasonable values. Google and Apple both trade at less than 20 times trailing earnings -- although Google just barely -- and have ample opportunity for growth. Meanwhile, many investors appear to have given up on Intel (Nasdaq: INTC) and Microsoft. However, both trade at around 10 times earnings and offer projected dividend yields of about 3%. I would expect explosive growth from either company, but the combination of low price and reasonable yield could reward the patient investor with solid returns.

If you would like more ideas for generating big returns while avoiding the growth trap, then you should check out this free report, "Secure Your Future With 11 Rock-Solid Dividend Stocks." The report is absolutely free!