Friday, June 13, 2014

The Growth Trap: IBM vs Standard Oil

Imagine it's 1950 and a decision needs to be made between two common stock investment alternatives:

- IBM (IBM)

- Standard Oil (now ExxonMobil: XOM)

IBM at that time had superior growth prospects compared to Standard Oil.

Below is a quick summary of the growth measures from 1950-2003 for both companies.*

Revenue Growth
IBM: 12.19% per year
Standard Oil: 8.04%

Earning Per Share Growth
IBM: 10.94%
Standard Oil: 7.47%

Dividend Growth
IBM: 9.19%
Standard Oil: 7.11%

Sector Growth
IBM: 14.65%
Standard Oil: negative 14.22%

So the advantage goes to IBM in every category except the one that really counts.

Standard Oil actually produced the better total return.

Total Return
IBM: 13.83%
Standard Oil: 14.42%

Why did Standard Oil's stock perform better? Simply put, it was the difference in valuation and the effect of dividends reinvested.

Average Price to Earnings
IBM: 26.76
Standard Oil: 12.97

Average Dividend Yield
IBM: 2.18%
Standard Oil: 5.19%

Those higher dividends reinvested, over time, in a stock with a more reasonable valuation made all the difference.** The end result being an investor in Standard oil increased their holdings by 15x while an investor in IBM only accumulated 3x more shares. IBM had vastly superior fundamentals over those 50 plus years. In fact, the market value of IBM actually went up more than Standard Oil. Yet, all those additional shares, bought with reinvested dividends, meant that the individual investor in Standard Oil ended up with the better overall result.

"...despite the better fundamentals, investors paid too high a price for IBM, while old Standard Oil was cheaply priced. I call this the 'growth trap.' Investors make the mistake of buying the new thing, irrespective of price." - Jeremy Siegel in an interview back in 2006

This is at least worth consideration the next time there's the temptation to pay a premium for exciting growth prospects. The return comparison is not all that matters, of course. IBM's results depended on much higher sustained growth. More risk was taken in the process simply due to the higher multiple of earnings paid. One of the best tools available to an investor to manage risk is price. That's under an investor's control; what happens as far as future growth goes is not.

Still, both IBM and Standard Oil generated very nice long run investment results. Things worked out well for long-term investors in both companies but, when you pay a high multiple, the margin of safety just isn't there to protect against what might go wrong.***

This naturally reveals nothing about the unique risks, challenges, and opportunities for these two businesses going forward. Future long-term investment results, at least to me, seem likely to be far more modest. No complaints if things turn out a bit better than expected, of course.

As always, it's not just about the absolute return; it's about judging risk versus reward and comparing to alternatives.

Unlike those 50 plus years, these days IBM has a much lower earnings multiple and, apparently, far less exciting growth prospects. Well, at least for now. It's never easy to tell, favorable or not, how those prospects might change over the very long haul. Price paid should assume and reflect the least optimistic scenario. (Especially for technology stocks.)

In other words, the expected outcome should be an attractive one even if nothing great happens.

If the likely worst case can't be judged with high confidence, buying makes no sense.

Adam

Small long position in IBM; no position in XOM.

Other related posts:
Asset Growth and Stock Returns, Part II - Mar 2014
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Technology Stocks - May 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* Source: The Future for Investors by Jeremy Siegel
** Dividend reinvestments function like buybacks but, compared to buybacks, are generally less tax efficient. This depends on the type of account. Other than the tax differences, buybacks and dividend reinvestments -- implemented at reasonable or better valuation levels (i.e. discount to value) -- similarly benefit long-term owners; the former reduces overall share count, while the latter increases the number of shares owned.
***  Both companies, inevitably, ran into plenty of their own specific difficulties over those 50 plus years. Even very good businesses will have their fair share of challenges. Anyone expecting a smooth ride investing in common stocks is, well, guaranteed disappointment.
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