These Stocks Are Growth Traps

When one of the best and brightest investors in academia speaks, you’d 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 Cree (Nasdaq: CREE) or Sirius XM Radio, two companies operating in difficult industries and with forward price-to-earnings ratios greater than 35, may not be Siegel's idea of a good investment.

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, Siegel uses an example of two opposing investments.

Consider an investor who put $1,000 in 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, Johnson & Johnson (NYSE: JNJ) or Exelon (NYSE: EXC). Both of these companies have one very important trait in common: They've been paying consistent dividends for more than 60 years. In fact, both have increased dividends at an average rate of at least 10% over the last five 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 Rackspace Hosting (NYSE: RAX) or Google (Nasdaq: GOOG), 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 P/E profiles similar to those of Johnson & Johnson and Exelon:

Data from Capital IQ, a division of Standard & Poor's.

These companies pay great dividends, trade cheaply, and sport extremely 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, necessary companies. They produce everything from washing detergent to Chef Boyardee to essential funeral services. 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" category.

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

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This article was originally published Nov. 7, 2009. It has been updated.

Fool contributor Jordan DiPietro owns shares of Exelon. Exelon is a Motley Fool Inside Value recommendation. Google and Rackspace Hosting are Motley Fool Rule Breakers selections. Clorox and Johnson & Johnson are Motley Fool Income Investor recommendations. Motley Fool Options has recommended a buy calls position on Johnson & Johnson. The Fool frequently reinvests in its disclosure policy.