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
Standard Oil of N.J.
|Revenue Per Share||12.19%||8.04%|
|Dividends Per Share||9.19%||7.11%|
|Earnings Per Share||10.94%||7.47%|
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.
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
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
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!
The Motley Fool owns shares of Microsoft, Apple, Intel, Cisco, IBM, and Google, has created a bull call spread position on Cisco, and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel, Cisco Systems, Google, Apple, Procter & Gamble, Microsoft, and salesforce.com, as well as creating bull call spread positions on Microsoft, Apple, and Intel. A separate service has recommended shorting salesforce.com. 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. The Motley Fool has a disclosure policy.
Fool contributor Patrick Martin owns no shares of any of the companies mentioned here. 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.