"The Growth Trap and How it Applies to Income Investing"

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In his latest book The Future for Investors, Jeremy J. Siegel addresses one of the fundamental reasons why investors fail to make as much money as they could -- growth investing.

He terms it, The Growth Trap.

Simply, investors are too prone to invest for growth and therefore pay too much for investments that are expected to grow quickly.

It's important to note something up front --


Of course, if the investment doesn't grow as promised, you the investor lose even more.

Some of us (yes, I'm including myself!) have bought penny stocks thanks to great stories. Many of these companies go out of business.

Many of you are smarter than that. You know penny stocks are a gamble.

So what do you do? You wait until the company is so successful and recognized that it's being hyped by the business magazines and even TIME and NEWSWEEK before you throw your money away on it.

You were smart enough not to buy Yahoo or Amazon when they were cheap penny stocks -- you waited until the national media was hailing Internet dot coms as the New Economy and they were selling at outrageous multiples of earnings. And many dot coms of that era didn't even have earnings.

The Dull Stock Beat Out the Sexy High Tech Stock

Anyway, Dr. Siegel makes a comparison between going back to 1950 and choosing to buy either IBM or Standard Oil of New Jersey

IBM was the high tech growth stock of 1950.

Standard Oil of New Jersey was an "old economy," worn out boring stock in a declining industry.

All predictions were that IBM would grow far more than Standard Oil of New Jersey and, as a company, all those predictions held true for the next 50 years. IBM's earnings, profits, sales and sector growth far exceeded that of Standard Oil of New Jersey's.

So which investment did the best? Of course -- Standard Oil of New Jersey.

If an investor put $1000 into IBM in 1950 and reinvested all dividends, by 2003 they had $961,000.

The investor who put $1000 into Standard Oil of New Jersey and also reinvested all dividends, by 2003 had $1,260,000.

Despite IBM paying a higher rate of dividends per share.

Reinvesting Dividends Works Better the More Shares You Can Buy

How'd that happen?

From 1950 to 2003 IBM's average P/E (price to earnings) was over 26.

From 1950 to 2003, Standard Oil of New Jersey's average P/E was 12.97.

That means that IBM would have had to grow twice as much as Standard Oil of New Jersey just to make up for the fewer number of its shares that the same amount of money would buy.

Plus, Standard Oil of New Jersey's average dividend yield from 1950 to 2003 was 5.19%.

IBM's was only 2.18%.

Therefore, Standard Oil of New Jersey was giving out twice as much money per price of its shares as IBM

So IBM would have had to grow four times as much as Standard Oil of New Jersey just to remain even.

When they each issued dividends each quarter, the Standard Oil of New Jersey's dividends were twice as much and yet they bought double the amount of stock.

Dr. Siegel's conclusion is that the long term return on a stock doesn't depend on the company's actual growth rate -- it depends on what the actual growth rate is compared to what investors EXPECT.

From 1950 to 2003, investors did not expect as much from Standard Oil of New Jersey as they did from IBM. And so it continued to be relatively cheaper . . . and dividend reinvestment bought relatively more shares.

Which in turn paid relatively higher dividends, which bought relatively more shares, and so on.

Of course, this is not really new. Benjamin Graham was preaching about value investing many years ago.

And in his book What Works on Wall Street, James P. O'Shaughnessy ran studies of various "value" and "growth" strategies

He found that the buying stocks with low P/E ratios was a successful strategy, particularly for large caps. Less so for smaller stocks -- apparently because some of the smaller stocks did actually grow very fast.

It seems crazy, but many people would rather pay $200 for a stock that pays $5 a year, because the company is on the cover of BUSINESS WEEK and his talked about on TV as a great growth company, than $100 for a boring stocks pays the same $5.

But you can buy twice as many dividends for your money with the boring stock than the exciting one.

Dr. Siegel Discovered the Growth Trap Applies to Entire Countries

He demonstrates that although the Chinese economy grew at a tremendous rate from 1992 to 2003, investors in Chinese companies did quite poorly . . . because they overpaid for the shares they bought.

In contrast, despite severe inflation and political turmoil, investors in companies in Brazil did quite well from 1992 to 2003.

Of course, the media was -- and still is -- enthusiastic about China's growth. And you hardly ever hear anything about Brazil in the news.

My conclusion -- investors who want high income should -- all other things being equal, which they aren't always -- buy companies paying relatively high dividend yields.

Another concept glorified by financial academics is of the dangers of active management and the promise of Market Indexing

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