These Stocks Are Growth Traps

When one of the best and brightest investors in academia speaks, you better believe I listen. That's why when Jeremy Siegel, author of Stocks For The Long Run, said that companies that experience rapid growth often don't generate good returns for investors, I stepped back and did a double take. Isn't that what we're always looking for: Companies that can grow, expand, and increase revenues and earnings? According to Siegel -- not really.

Don't fall for it
Siegel thinks that trailblazing stocks often do much worse than the plain-vanilla stocks in which no one is interested. Evaluating history, he says, "Although the earnings, sales and even market values of the new firms grew faster than those of the older firms, the price investors paid for these stocks was simply too high to generate good returns." These stocks are growth traps, in other words.

OK -- so we have to avoid companies trading at outrageously high levels, and particularly ones in uncertain industries, where potential growth is questionable. So scooping up shares of Yahoo! (NASDAQ:YHOO) or LDK Solar (NYSE:LDK), two companies in growth industries with forward price-to-earnings greater than 30, is not Siegel's idea of a good investment. In fact, he says that "higher prices mean lower dividend yields, and therefore fewer shares accumulated through reinvesting dividends."

The bottom line is that investors often expect a company to experience excessive growth, so they're willing to pay a very high premium for good companies with debatable growth. This, in essence, is what Siegel calls "the growth trap." This is what you need to avoid.

The critical factor
According to Siegel, there is but one critical factor when it comes to investing for the long run. Favor dividend-paying stocks, and reinvest those dividends. To illustrate his point, Professor Siegel uses an example of two opposing investments.

Consider an investor who put $1,000 in IBM (NYSE:IBM) in 1950, and another investor who put $1,000 in Standard Oil. Over the next 53 years, IBM was the winner -- dramatically beating Standard Oil in per-share revenue growth and earnings. However, shareholders from Standard Oil were the ultimate champions. Why? IBM's average dividend yield was 2.18% and it sold for 26.76 times earnings, while Standard Oil's average dividend yield was 5.19% and it sold for 12.97 times earnings. The higher dividend yield allowed shareholders who reinvested the dividends to accumulate more shares, which caused returns to multiply. The difference: Standard Oil shareholders ended up with almost a quarter of a million dollars more than IBM shareholders.

Siegel found that over the same time period, the best-performing stocks were companies with strong dividends -- for example, Coca-Cola (NYSE:KO) or ExxonMobil (NYSE:XOM). Both of these companies have one very important trait in common -- they've been paying consistent dividends for more than 100 years. In fact, both have increased dividends for the last 25 years. That, according to Siegel, is another important factor.

Triumph with simplicity
It's difficult not to get wrapped up in new industry stocks. They're exciting; you envision yourself investing in the next Sun Microsystems (NASDAQ:JAVA) or Intuitive Surgical (NASDAQ:ISRG), and it's hard to resist the temptation. They're good companies that may very well outperform over the long term. But Siegel clearly advocates looking for the boring companies with low price-to-earnings ratios and high dividend yields -- traditional firms that collect trash, pump oil, or market soft drinks and chips.

For example, here are some lesser-known stocks that currently have manageable payout ratios and similar P/E profiles to those of Coca Cola and ExxonMobil:

Data from Yahoo! Finance.

These companies pay great dividends, trade cheaply, and sport reasonable payout ratios that indicate they're not vulnerable to future dividend cuts. Too high of a payout ratio is dangerous -- should a company's earnings decrease unexpectedly, it may have to cut dividends. Companies try like heck not to do this, because it makes investors and analysts panic. Additionally, these are predictable, essential companies -- they produce phosphates for food production; manufacture commercial wood treatments for the chemical, railroad, and steel industries; and distribute spirits, beer, and wine. While I always suggest doing more due diligence before drawing a conclusion about any stock, I can definitely say these are not the types of companies that fall into the "growth trap."

Just like Jeremy Siegel, our analysts at Income Investor look for a few simple attributes. They buy cheap. They buy reputable companies. And most importantly, they reinvest dividends. And ultimately, they've proved successful: Since inception, our team is beating the S&P by more than seven percentage points.

If you're interested in seeing all of our past and present recommendations, plus the seven stocks we think you should "buy first," click here for more information. We're offering a free 30-day trial. There's no obligation to subscribe.

Already subscribe to Income Investor? Log in at the top of this page.

Fool contributor Jordan DiPietro owns no shares of the companies above, but loves seeing his dividends accumulate more shares. Intuitive Surgical is a Rule Breakers pick. Coca-Cola is an Inside Value pick, and both Coca-Cola and Diageo are Income Investor recommendations. The Fool owns shares of Innophos. The Fool frequently reinvests in its disclosure policy.