It's Still Stocks For The Long Run
The professor who taught America to love stocks in the 1990s is as optimistic as ever. But he's added a new twist to his theory: Get dividends
By Pablo Galarza

(MONEY Magazine) – Jeremy Siegel was the intellectual godfather of the 1990s bull market. His 1994 book Stocks for the Long Run sealed the conventional wisdom that most of us should be in the stock market. Even if you don't recognize the academic economist's name, you've certainly heard brokers and financial journalists recite his factoids: that over the long term, stocks have nearly always outperformed bonds. That stocks are actually less likely to lose money over time, after inflation, than bonds are. And that even if you bought some of the most expensive stocks at the worst possible time—Siegel cited the notorious "Nifty Fifty" growth stocks of the early 1970s—you could still make money as long as you just hung on. In short, Siegel made stocks seem a lot less scary. It's no wonder that brokers and financial planners bought copies of his book by the box load.

After the crashes, the scandals and the just plain lousy stock returns of the past five years, you might think that Siegel, 59, would be chastened. If he is, it doesn't show. He remains adamant that stocks in general are the way to go for buy-and-hold investors, and he thinks we're about to see the greatest era of growth and innovation the world has ever known. But his experience during the bubble has spurred him to refine his argument. In his forthcoming book The Future for Investors, Siegel says that stock pickers do better when they ignore the fastest-growing businesses and focus instead on big, boring companies with fat dividend yields. In a conversation in October near the campus of the University of Pennsylvania, where he's worked for 29 years, the incorrigible optimist made the case for a little more caution and shared some provocative ideas about the risks and opportunities that lie ahead over the next 30 years.

Q. In the 1990s a lot of people used your finding that stocks nearly always make money in the long run to justify some pretty aggressive investing. Did you feel like Dr. Frankenstein—you know, like, "I've created a monster"?

A. [Laughs.] Somewhat. I worried that people would interpret my message as "Just buy stocks without any attention to price." Now I wish that in the second edition of Stocks for the Long Run I would have warned much more loudly—but at that point it wasn't as out of hand as it got. And I was speaking out in 1999 and 2000 against what was going on with Internet and technology stocks.

Still, if you ride the bubble up and down, you do darn well indexing the stock market in the long run—about 7% annualized, after inflation. I never told people that there wouldn't be a bubble or a bear market. I just said that indexing has done well over time.

Q. Would you modify the message now? A. I now think that you could do better. After what I saw in 2000, I concluded that by applying some common sense and reducing your exposure to the hottest sectors and stocks, you could pick up about half a percentage point more return, on average, each year. If you just stay away from these manias, you've got an edge.

Q. Did your own experience as an investor help you to see this? A. The Internet and technology bubble was going on and I found myself saying that it was crazy. Here I was, the bull of the stock market, and I'm saying that things are out of hand. At the top of the bubble, I moved away from tech stocks. I repositioned my-self. I still held money in an S&P 500 index fund, so I didn't entirely sidestep it, but I moved a lot into value. And boy did that help me on the downside.

Then I said, if I did that and it helped so much, let me explore whether staying away from wildly priced growth stocks is something that works over much longer periods of time.

Q. So does it work? A. Yes. The constant pursuit of growth—buying hot stocks or sectors or seeking out the next big thing—dooms investors to poor returns. If you'd invested $1,000 in 1957 in the 100 stocks in the S&P with the highest price-to-earnings ratios, and rebalanced annually, you'd have had $56,700 by 2003; if you'd bought the 100 stocks with the lowest P/Es, you'd have had $425,700. [The S&P 500 index was created in 1957.] My research finds that investors consistently overpay for growth. I want people to think about investing this way: The great growing companies are not often the ones that give you the best returns. The tried and true triumph over the bold and new.

Q. Why do you think investors are so willing to overpay? A. It's because they notice these big hits and entrepreneurs who have become rich through the invention of some innovation. And they start thinking, "I've got to get into these companies." But the benefits of all this growth are not funneled to individual investors but to the innovators, the founders, the venture capitalists who fund the projects, the investment bankers who sell the shares and ultimately to the consumers who buy better products at lower prices.

Q. So which stocks should we be looking at instead? A. I can't emphasize enough the importance of dividends and reinvesting those dividends. You'll find that dividend payers that trade at reasonable valuations are the stocks that did the very best for investors over the long run. One of the things I note in the new book is that the 100 highest-yielding stocks in the S&P 500 have done better than the index as a whole over the past 50 years.

I ask people which is the best-performing stock over the history of the S&P 500 index. Almost no one picks Philip Morris, now Altria (MO). It was a fast-growing company, but its P/E always stayed low. And it paid a great dividend. So its return was three percentage points a year higher than any other stock on the index for almost half a century. That performance turns $1,000 in 1957 into $4.6 million by 2003. If you held your $1,000 in an index fund over the same period, it would be worth $125,000.

Again, no one can guarantee in the short run that this works, but over the long run, I think you can accrue a little better return on the market by focusing on dividend payers. I think we need more index funds that track just stocks with dividends. There's only one: Barclays' iShares Dow Jones Select Dividend Index (DVY) exchange-traded fund.

Q. You observed in Stocks for the Long Run that investors could make money even if they bought the high-flying stocks of the 1970s at their peak. Now you're saying that investors shouldn't buy expensive stocks. A contradiction? A. I'll tell you why it's not contradictory. Among the fast-growing stocks dubbed the Nifty Fifty, those in the cheapest 25 did much better than the more expensive half. I mention that in the third edition of Stocks for the Long Run.

Q. So should I avoid all growth stocks? A. When people are paying 100 times earnings for big companies, you better watch out. But right now growth stocks look cheap to me. You shouldn't be afraid to pay for growth. The average P/E ratio of what I call the El Dorados—the 20 top-performing companies since the inception of the S&P 500—was a few points above the market's average. But none had a P/E over 27. [The S&P 500's average P/E today is 20.] That links well with my findings on the Nifty Fifty. The most expensive ones—the tech companies like Polaroid, Digital Equipment, Texas Instruments, IBM—didn't do well at all. Among the Nifty Fifty companies, only Johnson & Johnson, in retrospect, deserved a P/E over 50. The key, and it's a theme I talk about again and again, is not wildly overpaying. You almost never want to pay over 30 times earnings.

Q. You have critics—some of them writers for this magazine—who worry that you make too much of the past performance of stocks. They say investors in the future are unlikely to get that 7% return you talk about. A. In the past, returns have been greater than they'll be in the future. That's because of the Great Depression, which kept prices down for a while. So that 7% figure is really the top end of the range. I now say that returns after inflation could be 5% to 7% in the future. The gap between stock and bond returns will be smaller in the future than it was over the past 100 years. But stocks will still probably beat bonds by somewhere in the neighborhood of three percentage points a year.

Q. You open The Future for Investors with a declaration: "Our world today stands at the brink of the greatest burst of invention, discovery and economic growth ever known." That sounds so 1999. A. With all these pessimists around, I want people to know that I'm very optimistic about the future. I really think—and this is ironic because I came out against Internet stocks in April 1999—that the Internet is opening up parts of the world to information and knowledge that people in these countries have never had access to before. It is on the order of magnitude of the invention of the printing press; it is that impressive. And we are only in the early stages.

For instance, there are people in China and India who are extraordinarily bright and who have never been exposed to this information before. So they'll take it and make something great with it. That could usher in a very dramatic period of growth. The Internet is important. But remember the growth trap: Just because it is important to the economy or to innovation or to growth in productivity doesn't make it a good bet for investors. There is a difference between the company being successful and the investment being successful.

Q. The other big issue you tackle in the book is the worry about the impact of baby boomers on the stock market. What's the risk there? A. The most frequently asked question I get after "Which stocks for the long run?" is "What about the baby boomers?" Because when you're telling people to look to the long term—20 or 30 years from now—you would be remiss not to address the effects of the baby boomers retiring. So the second part of the book examines the crisis that ensues when the baby boomers start retiring and selling off their equities and bonds to fund their lifestyle. All this stuff about the future being like the past, you can throw it away if this "age wave" is so unique that it can't be handled by the market.

Q. Where do you come down? A. I say that given all that evidence, does the baby boomer wave make things fundamentally different? No. In fact, I argue that it could accelerate world growth. There's no question that people will be older and retiring, but at the same time we have this explosion of development of knowledge, and rapid growth of the developing world, which is much younger. It's fortuitous that it comes just as baby boomers are moving into retirement.

Q. What does the developing world have to do with keeping the U.S. stock market moving? A. This idea is disturbing to a lot of people. The U.S. won't be the biggest world economy and won't have the most wealth. These newly prosperous countries will be exporting goods that the boomers need, and then they will use the dollars that we use to pay them to buy our assets—Treasuries, corporate bonds, real estate and stocks. We're seeing the very beginning of it with Treasuries. That's how our budget deficit is being financed.

Q. That's exactly what worries a lot of bears. They say that at some point foreigners are going to stop investing here. A. Not as long as the developing world keeps getting richer, which I think it will over the next 20 to 30 years. They have little in the way of financial assets now, but they'll be earning more and accumulating money to invest. And they're going to see good stock values here. Believe it or not, their companies will be highly valued—they'll be growing faster than U.S. companies but have high P/Es. They will want to diversify.

Q. Does it bother you that people think of you as such an unremitting bull? A. As long as you make that "long-term bull," no. When I talk about the long-term rates of return of stocks, 5% to 7%, people say that's not exciting. I say that's a good bit better than bonds and anything else.