This week, Gail reviews renowned finance professor Jeremy Siegel’s new book — and she is giving away free copies!

Dear Friends,

Prof. Jeremy Siegel is EF Hutton for the masses: when he speaks, we listen.

The Wharton business school professor’s last book, Stocks for the Long Run (1993), was a best-seller — no small feat for a financial title. In it, Siegel pointed out that, for long-term investors — those with at least a 20-year time horizon — stocks had historically provided a better return than any other asset class.

He recommended a buy-and-hold strategy and said index funds were the best way to go, partly because their expenses are lower, but mostly because “the index outperforms 80 to 90 percent of all portfolio managers.”

To be sure, Siegel wasn’t the first person to point out the virtues of owning equities. But his book, written in clear, everyday language with the layperson in mind and supported by his extensive research, made the argument especially persuasive and unquestionably contributed to Americans’ love affair with stocks in the 1990s.

It also vaulted Siegel to rock-star status in the financial world.

But as stock prices climbed higher and higher into the stratosphere toward the end of the decade, Siegel grew uncomfortable. Never before had investors paid so dearly for so little in return. By all traditional measures — Price/Earnings, Dividend Yield, Price-to-Book — stocks had become historically — or was it hysterically? — expensive.

Siegel admits he seriously questioned the main message he had hammered home in Stocks for the Long Run. At these prices levels, were stocks really the best investment “for the long run?” Moreover, Siegel’s readers wanted to know if it still made sense to invest in stocks via broad-based index funds like the S&P 500and Wilshire 5000.

Feeling pressure to weigh in on the issue, Siegel studied the stock market and came to a conclusion that was published in an op-ed piece in The Wall Street Journal: stocks in general weren’t overpriced, he said. Instead, the averages were being skewed by technology stocks, which were being bid up to ridiculous levels.

Later, in a second Wall Street Journal commentary, he specifically warned against investing in “large cap” tech stocks.

The problem, of course, was that by then these stocks represented roughly one-third of the value of the S&P 500 index — the very index Spiegel had extolled in his book.

Of course, not everyone who had read Siegel’s book saw his opinion pieces. And surely, even those who did were too giddy with the double-digit returns on their Internet funds to pay much attention. The painful three-year decline that started in March 2000 made Siegel and probably many, if not most, of his readers question the wisdom of owning stocks at all.

Siegel responded in true academic fashion: he launched a massive research project. Not to figure out what caused the market to collapse (by then it was obvious), but to explore whether there was a better/smarter way to invest in stocks. His conclusion fills his latest book, The Future for Investors, and runs contrary to everything you’ve probably heard or believe about how to make money in the stock market.

Essentially, it boils down to this: avoid the new, flashy, growth companies and seek out the older, stodgy, boring ones.

Huh?! Why wouldn’t you want to own cutting-edge companies with great growth potential? Aren’t they expected to see their earnings increase year after year as more and more customers clamor for their products?

Well, for starters, growth stocks tend to be expensive, meaning their prices are already inflated by the great expectations people have for the. “The first mistake people make,” says Siegel, “is paying too much for a stock. They think price is secondary and that ‘growth will bail me out.’ They’re wrong.”

Those who succumb to the “growth-at-any cost” philosophy (I can personally think of several former mutual fund managers who fit this description) have been suckered into what Siegel calls “The Growth Trap.”

Second, flashy new upstarts in promising sectors (did someone whisper “biotech”?) spend money like water. Any extra cash they have is used to fund their expansion. In other words: they don’t pay dividends. And dividends, says Siegel, is the second key to making money in stocks.

Case in point: roll back the clock to 1950, the dawning of the “Information Age.” Let’s compare a company called Standard Oil of New Jersey (now Exxon Mobil (XOM)) to a new-economy darling called International Business Machines (IBM).

If you had $1,000 to invest and could only pick one of these companies, which would it be?

Now fast-forward to the end of 2003. Looking back, Siegel points out that by all the yardsticks Wall Street uses IBM was the “better” stock. Over this time period, its annual revenue per share exceeded 12 percent, while Standard Oil’s was 8 percent.

IBM’s earning per share grew by nearly 11 percent vs. 7.5 percent for Standard Oil.

There was even a role reversal in terms of the industry each company is in. The computer/technology sector grew by more than 14 percent; by late 2003 stocks in this sector represented nearly one-fifth of the value in the total stock market..

In contrast, the oil sector shrank by 14 percent.

Yet over this 53-year period an investor in Standard Oil, who reinvested her dividends to buy more shares, earned 24 percent more than an IBM investor following the same strategy.

Why? Because the IBM investor paid too high a price. And over the years, IBM’s price continued to increase, which meant that reinvested dividends bought fewer and fewer additional shares.

Think of this another way. Suppose you’ve had it with corporate America and are looking to buy a small business that you can your spouse can run. You narrow it down to the following two prospects:

One is “Mabel’s,” a candy/newspaper store that’s been around since the 1960s and is located in a blue-collar neighborhood two train stops from the city. Owners Mabel and Emil are selling so they can retire to Florida.

“Mabel’s” comes with the original (still functional) soda fountain with swivel seats and the secret recipe for Mabel’s famous grilled cheese sandwich. Though the accents in the neighborhood have changed over the years (Emil now speaks a passable Spanish), the customers are cut from the same cloth: hard-working parents with large families who want to see their kids succeed.

“Mabel’s” clears $6,000/month. They’re asking $150,000.

Your second choice, “Lattes and Laptops,” is a flashy Internet coffee bar in an up-and-coming yuppie neighborhood in the city. The owners, Jarrod and Jeannette, launched it a year and a half ago and expect it to be turning a profit in a couple of years once the expresso machine, wi-fi electronics and trendy booths are paid off. There’s talk that a developer may convert some lofts around the block to condos, which should boost business.

Jarrod and Jeannette hate to leave, but they’re starting a family and want to move to the suburbs.

Asking price: $400,000.

DO THE MATH!

If “Mabel’s” generates $6,000/month in profits (“free cash flow” in Wall Street terminology), you’ve broken even on your investment in a little more than two years. From there on, it’s gravy.

Who knows how long it will take for “Lattes and Laptops” to turn a profit— if ever. And once it does, how many tens of thousands of coffees and muffins will you have to sell before you recoup your original investment?

In other words, to quote Siegel, “Valuation matters!”

Or, as Buckner would say, “He/she who overpays, waits longer to reap a profit.”

The IBM-Standard Oil comparison isn’t unique. When Siegel looked at the 50 largest companies in the S&P Index in 1950, he found that the four top- returning stocks all came from “old economy” industries:

National Dairy Products (now Kraft Foods)

RJ Reynolds Tobacco

Standard Oil of NJ (Exxon Mobil)

Coca-Cola

What they all have in common, according to Siegel are the following characteristics:

1) Recognized brand name products that are

2) Sold both inside and outside the United States (i.e. “global”) and

3) Management “didn’t try to be everything to everyone. They stuck to what they do best.”

Ironically, Siegel’s latest research argues against one of the core recommendations of his previous book, i.e. investing in a broad index like the S&P 500 and holding this for the “long run.” That’s because the S&P 500 (this would be true of any index, including the Dow Jones Industrial Average) is not a static grouping of companies. Instead, it is periodically re-shuffled to more accurately reflect the overall market. This means that some existing companies are removed to make room for new firms in growing industries!

In other words, the very nature of a market-weighted index like the S&P 500 requires that it drop the stodgy, old-line firms and add the flashy, cutting-edge companies which now represent a bigger share of the stock market as a whole because their prices have been driven up.

Exactly the opposite approach Siegel now advocates!

“What shocked me the most,” says Siegel, “is that the original 500* out-performed the updated S&P.” This means that the new stocks that have been added over the past 50+ years have actually been a drag on performance; the S&P 500 would have had a better return without them.

Who would have thought that, as Siegel puts it, “the lowly railroads, despite shrinking form 21 percent to less than 5 percent of the industrial sector, outperformed the S&P 500 Index over the last half century?”

Indeed.

Can you imagine how you might have reacted if your financial advisor had called in 1999 with a hot tip on, er, railroads. "Excuse me, did you say 'railroads?' Are you out of your & %?<# mind?! All my friends are snapping up dot-coms and you want me to throw money at the railroads?!"

That, my friend, is precisely the type of thinking Dr. Siegel is now advocating. It’s not unique, but it’s certainly not as sexy as the hot-stock-of-the-day. A few really smart people have been taking this approach for years and doing quite well. Warren Buffett, for instance. It’s essentially “contrarian” investing, i.e. buying what the “herd” is ignoring.

Frankly, it’s easier said than done. Goes against human nature. Also doesn’t do much for your ego. Bragging about your reinvested dividends certainly doesn’t elevate your status at the company water cooler the way taking a risky (though stupid) stake in an IPO does. So you’ve got to decide what’s more important: making serious money or impressing your buddies.

It takes a little more effort to follow Siegel’s advice this time around. While he says putting some of your equities money in an index fund is OK, you will want to augment this with stocks that are out of the limelight and pay dividends.

Remember that price matters, so look at a stock’s Price/Earnings ratio. (Current price per share divided by its 12-month earnings.) Compare this to the P/Es of similar companies.

While a low P/E can be a sign of a company in trouble, a firm with a P/E significantly higher than that its competitors is a sucker’s bet.

Dividends are a crucial ingredient. Focus on a stock’s total return, not just how much its price goes up, or capital appreciation. “Total return” includes capital appreciation plus dividends paid. The most profitable stocks to own over the past 50 years all paid dividends. Reinvest them by buying additional shares of that company.

It’s counter-intuitive, but here’s the thing you’ve got to understand: When you’re reinvesting your dividends, you don’t want the price of a stock (or mutual fund for that matter) to skyrocket. Because your reinvested dividends won’t buy as many shares. And accumulating shares is what it’s all about. So look for a company whose dividends are increasing at a faster rate than it stock price.

In the second half of his book, Siegel tackles the changing global demographics. Contrary to doomsayers who predict the financial markets will tank when baby boomers sell their investments to finance their retirements, Siegel is an optimist.

He admits there may not be enough American buyers for the investments baby boomers will sell, but points out that while the populations of the industrialized world — the U.S., Western Europe, Japan — are aging, “80 percent of the world is very young and will play an increasingly important role in the future of our world economy.”

In fact, Siegel predicts that a growing investor class in today’s developing nations, especially China and India, will be hungry for U.S. investments and will happily snap up the investments that baby boomers eventually unload.

What’s that? American companies owned by foreigners? Siegel sees it as inevitable. “There’s nothing we can change,” he says. In fact it’s already happening, my friends. IBM recently completed the sale of its personal computer business to Chinese company Lenovo. (Before you panic, recall all the hand-wringing that took place 20 years ago when certain financial gurus predicted the Japanese would buy up American real estate. Pebble Beach!)

But I digress. The point is, Siegel’s so bullish on the economic growth expected to come from emerging markets, he recommends that up to 40 percent of your portfolio be invested in non-U.S. securities.

As the good professor puts it, “I love “growth” — economic growth. That’s fantastic! That’s what’s going to keep the stock market up as baby boomers retire. But I don’t love growth stocks.

It’s still “stocks for the long run.” You just need to do more homework to find them. And think “global.”

Keep the Faith,

Gail

BOOK OFFER: 30 “Your $ Matters” readers will receive a complimentary copy of Jeremy Siegel’s new book, The Future for Investors.

Send me a brief email with The Future for Investors in the subject line and explain why you need this book or how you’d use it. Winning submissions will be announced in an upcoming column. You must include your U.S. Post Office address to be considered!!!

* Though we refer to it as the S&P 500, as Siegel explains, the index didn’t always include so many companies. Back in the 20’s, for instance, it only had 90. It didn’t expand to 500 stocks until 1957.

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