As the rest of the world lay in ruins, the United States was pretty much the only country left with production capacity intact post World War 2. And with a lot of rebuilding that was to follow meant that the factories there had to run overtime to meet the inexhaustible demand.
Plus, with exploding domestic consumption as the returning soldiers bought homes and filled those homes with wives and babies, appliances, gadgets, and automobiles, meant that it was nothing but boom times for businesses all around. New products were being created, technological breakthroughs were happening everywhere and a quintessential company at the forefront of all that boom was IBM. IBM was tech before tech became tech. It was the cutting edge.
So, say in 1950, you were trying to decide between two investments, IBM and Standard Oil of New Jersey (ExxonMobil of today), which one would you have picked? Standard Oil of NJ is how I’d define a business that is established with a growing clientele, but at no point would the demand for their products is expected to shoot the lights out.
IBM, on the other hand, backed with unmatched financial power, was literally present at the onset of the computing revolution and was expecting to serve a humongously, growing market.
Which one would you have picked then? Jeremy Siegel, professor of finance at the Wharton School in his book The Future for Investors, lays out this growth trap by providing data on key financial metrics that any ‘real’ investor would look at to evaluate a potential investment.
IBM did better than Standard Oil on almost all metrics that matter. Plus, as information technology advanced and computing became an integral part of the global economy, the tech sector which IBM was a big part of, grew from a mere three percent of the stock market to almost 18 percent.
Oil sector’s representation on the other hand, which Standard Oil was again a big part of, shrunk drastically from 20 percent of the stock market’s value to less than five percent.
So, now with this data and with near perfect foresight, you would have picked IBM. And if you did, you did well.
But the shocker is that had you picked Standard Oil, you would have done even better.
How is this possible? How did Standard Oil out earn IBM even though IBM beat Standard Oil on every relevant growth measure?
Expectations.
Expectations that were built into the valuation of IBM. And that is typical of most growth companies where investors expect more growth and pay for that growth through ever higher stock prices.
But then the realized growth don’t match expectations and hence the performance gap.
IBM was expected to grow faster than Standard Oil so investors bid up its share price to a point that even though growth followed, it was not enough to out earn investors’ expectations.
Standard Oil, a supplier of commodity products on the other hand, was not expected to create magic and hence was valued accordingly.
But investors’ expectations turned out to be lower than what Standard Oil came to deliver and hence the outperformance.
Obvious prospects for physical growth in a business do not translate into obvious profits for investors.
Benjamin Graham, The Intelligent Investor
What applies to companies also applies to sectors.
Compare for example the financial sector with the energy sector and their respective representation in the S&P 500 index at the start and at the end of the period. Even though the financial sector grew from being less than 1% of the index to about 20% and even when the energy sector shrunk from about 22% to 6%, the actual sector return differences were not that far apart.
In fact, the energy sector out earned the financial sector on average (refer to the Actual Sector Return column).
Part of the reason for the financial sector’s underperformance relative to the energy sector was due to the constant addition of new businesses that diluted some of that growth.
But a much bigger reason for the relative underperformance was the valuation investors were willing to pay for the expected future growth.
Inquiring minds might want to know the difference between the last two columns in the table above so let me talk about that. We know how an index is created and how it evolves over time. Companies get added and deleted based on what the index creators think is a good representation of the economy at any given time. The composition of the index hence changes as the economy evolves through replacement of the old with the new.
But had the index constituents remained unchanged, the return you would have earned is what the last column shows. The second to last column is the performance of the actual index that takes into account all the additions and deletions.
So, if you bought once and just held, you did better than all the changes you would had made over time. Now that again is a remarkable testament to the power of doing nothing and holding on for the long-term.
Plus, what companies do you think get added to an index? The darlings of today.
And what gets booted out? The also rans.
But the darlings of today don’t come cheap. Expectations are high and you pay for it through a richer stock price. Hence the underperformance.
What applies to sectors also applies to stock markets of entire countries. A faster growing country does not automatically translate into better stock market performance.
History shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.
Jeremy Siegel, The Future for Investors
That’s one of the reasons why investing in IPOs is usually a terrible deal. You pay through the nose for the anticipation of inflated future growth but when that growth does not materialize, you are left holding the bag.
Yet the benefit of all this growth are funneled not to individual investors but instead to the innovators and founders, the venture capitalists who fund the projects, the investment bankers who sell the shares, and ultimately to the consumer, who buys better products at lower prices. The individual investor, seeking a share of the fabulous growth that powers the world economy, inevitably loses out.
Jeremy Siegel, The Future for Investors
But then we want the innovators and founders and folks who risk their capital to be rewarded. And they do. But the rewards to the public market investors are few and far between.
So, until incentives get better aligned, stay away.
In summary, if you are looking to invest in something, anything that excites you based on how fast a company or a sector or a country is growing, you know how that’ll likely turn out.
But if you decide to stick with the dull and the boring, you’ll do fine. And oftentimes much better. Not because there is anything special with that strategy but because with the dull and the boring, the expectations better match reality.
And that is the key.
Thank you for your time.
Cover image credit – Pixabay