10 insurance carriers. Until that year, the only financialstocks in the index were consumer finance companies because banksand insurance companies were traded in the “over-the-counter” (OTC)market and timely price data were not available until the Nasdaq Exchange began in 1971. In 2000, at the peak of the technology bubble, 49new firms were added to the index, the highest since Nasdaq stockswere included in 1976. In 2003, just after the bottom of the subsequentbear market, the number of additions fell to a record-tying low of 8.
SECTOR ROTATION IN THE S&P 500 INDEXThe evolution of the U.S. economy during the past half century hasbrought about profound changes in its industrial landscape. Steel,chemical, auto, and oil companies once dominated our economy.Today healthcare, technology, finance, and other consumer servicesfirms hold sway.Increasingly, active investors are using sector analysis to allocatetheir portfolios. The most popular industry classification system wasformulated in 1999 when Standard & Poor’s joined Morgan Stanley tocreate the Global Industrial Classification Standard (GICS). This systemarose from the earlier Standard Industrial Code (SIC) system devised bythe U.S. government that had grown less suited to our service-basedeconomy.21
Criteria for listing and other information are found on Standard & Poor’s Web site www2.standardandpoors.com/spf/pdf/index/500factsheet.pdf.2In 1997 the SIC codes were expanded to include firms in Canada and Mexico, and the revised listing was renamed the North American Industrial Classification System (NAICS).
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The GICS divides the economy into 10 sectors: materials (chemicals, papers, steel, and mining), industrials (capital goods, defense,transportation, and commercial and environmental services), energy(exploration, production, marketing, refining of oil and gas, and coal),utilities (electric, gas, water, and nuclear generating or transmissionfirms), telecommunication services (fixed line, cellular, wireless, andbandwidth), consumer discretionary (household durables, autos, apparel, hotels, restaurants, media, and retailing), consumer staples (food,tobacco, personal products, retailing, and hypermarkets), healthcare(equipment producers, healthcare providers, pharmaceuticals, andbiotechs), financial (commercial and investment banking, mortgages,brokerage, insurance, and real estate [REITs]), and information technology (software services, Internet, home entertainment, data processing,computers, and semiconductors).The share of the market value of each of these sectors in the S&P 500Index from 1957 through 2006 is displayed in Figure 4-1. Many of theFIGURE
4–1
Changes in Sector Weighting, 1957 through December 2006
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PART 1 The Verdict of History
changes have been dramatic. The materials sector, by far the largest in1957, has become the smallest today. The materials and energy sectorsmade up almost one-half of the market value of the index in 1957, buttoday these two sectors together constitute only 12 percent of the index.On the other hand, the financial, healthcare, and technology sectors,which started off as the three smallest sectors and comprised only 6 percent of the index in 1957, held one-half of the market value of all S&P 500firms in 2007.It is important to realize that when measured over long periods oftime, the rising or falling market shares do not necessarily correlate withrising or falling investor returns. That is because change in sector sharesoften reflects the change in the number of firms, not just the change in thevalue of individual firms. This is especially true in the financial sector, ascommercial and investment banks, insurance companies, brokeragehouses, and government-sponsored enterprises such as Fannie Mae andFreddie Mac have been added to the index since 1957. The technologyshare has also increased primarily because of the addition of new firms.In 1957, IBM was two-thirds the technology sector; in 2007, IBM wasonly the third largest in a sector that contains 74 firms.The returns of the 10 GICS sectors against the change in their market share over the past 50 years are plotted in Figure 4-2. The fast-growing financial and technology sectors have had only mediocre returns.The weight of their sectors has increased not because the prices of individual firms have risen but because many new firms have been addedto the index.In contrast, the energy sector shrunk from 22 to 8 percent of themarket weight of the index, yet its return of 12.87 percent is well abovethe S&P 500 Index. Statistical analysis shows that over the past 50 yearsonly 20 percent of the return to a sector is related to whether the sectoris expanding or contracting. This means that 80 percent of the investorreturn of a sector is based on the valuation of the firms in the sector, notthe relative growth of the industry. Rapidly expanding sectors often induce investors to pay too high a price, which results in lower returns.As a result, the best values are often found in stagnant or declining sectors that are ignored by investors and whose price is low relative tofundamentals.The performance of the 20 largest companies that Standard &Poor’s put into their first list in 1957 is shown in Table 4-1. One featurethat stands out is that all 9 oil companies on the list finished in the top 10,with only General Electric nudging ahead of Phillips Petroleum and Texaco for eighth place. The returns on all the oil companies beat the S&P
CHAPTER 4 The S&P 500 Index
FIGURE
55
4–2
Change in Sector Weights and Returns, 1957 through December 2006
500 by between 80 and 310 basis points per year despite the rapid shrinkage of the oil sector relative to the rest of the market.The top-performing stock of the original 20 largest was SoconyMobil Oil, which dropped the Socony, which stood for Standard Oil ofNew York, in 1966 and merged with Exxon in 1999. The second-best-performing stock was Royal Dutch Petroleum, a firm founded in theNetherlands, and one of the companies that Standard & Poor’s deletedfrom its index in 2002 when it purged all foreign-based firms. The thirdbest performer was Standard Oil of New Jersey, which changed its nameto Exxon in 1972 and is currently the largest-market-value stock not onlyin the United States but in the entire world.Fourth-best performing stock was Shell Oil, a U.S.-based companythat was purchased by Royal Dutch in 1985. Next was Standard Oil ofIndiana, which merged into BP Amoco in 1998. Sixth-ranking Gulf Oil,seventh-ranking Standard Oil of California, and tenth-ranking TexasCo. (Texaco) eventually merged to form ChevronTexaco, while ninth-
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PART 1 The Verdict of History
TABLE
4–1
50-Year Returns of the 20 Largest Companies in 1957
CHAPTER 4 The S&P 500 Index
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ranking Phillips Petroleum, merged with Conoco (Continental Oil Co.)to form ConocoPhillips in 2002.The only firm to beat any oil firm is General Electric, founded in1892 as a result of the merger of Thomson Houston and Edison GeneralElectric, the latter founded by Thomas Edison. As noted in the last chapter, General Electric is the only member of the original Dow Jones Industrial Average that has survived intact today. Although GE is listed inthe industrial sector, about one-half its revenue comes from its financialand healthcare divisions and NBC.Two other companies of the original largest 20 bested the performance of the S&P 500 Index over the last half century. They are Sears andRoebuck, thanks to the transformation wrought by Eddie Lampert, whochanged the stodgy retailer into a dynamic hedge fund operation. Theother is IBM, a firm that in 1957 was two-thirds of the value of the techsector and has just been able to beat the S&P’s return since 1957.3Eight of the original 20 largest companies lagged the performanceof the S&P 500 Index. Two deserve attention. U.S. Steel and AT&T wereat one time the largest corporations in the world. Through industrialchanges and corporate divestments, they shrunk to a tiny fraction oftheir former size, but they have been revived, and as of 2007 they are expanding rapidly.U.S. Steel was formed in 1901 from the merger of 10 steel companies,led by Andrew Carnegie and financed by J. P. Morgan. After the merger, itwas the first billion-dollar-sales company in history, and it controlled twothirds of the U.S. market. To cushion itself against rising energy costs, itbought Marathon Oil Company in 1982 and renamed itself USX Corporation. In 1991, U.S. Steel was spun off as a separate firm, and in 2003, thevalue of its shares sank to just over $1 billion, the same size as it was a century earlier. Aggressive cost cutting has brought U.S. Steel back, and it isnow the second-biggest steel producer behind Mittal Steel USA, whichpurchased, among other steel firms, the bankrupt assets from BethlehemSteel, the eighteenth-largest company in the S&P 500 Index in 1957.American Telephone and Telegraph Co. was the largest company inthe world when it joined the S&P 500 Index in 1957, and it remained thatway until 1975. The company boasted a market value of $11.2 billion in1957, a capitalization that would rank in the bottom 200 of the S&P 500firms in 2007. The telephone monopoly known as “Ma Bell” was brokenup in 1984, giving birth to the “Baby Bell” regional providers. But the3
Today IBM is only 7 percent of the technology sector, and its market value is eclipsed by bothMicrosoft and Cisco.
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PART 1 The Verdict of History
stripped-down AT&T was bought by one of its children, SBC Communications, in 2005, and through other acquisitions, it worked itself back tothe top 20 in market value in the United States by 2007. The 50-year return on AT&T, had you also held all the Baby Bells when Ma Bell spunthem off 23 years ago, would have given you a 10.77 percent annual return, virtually matching the index.General Motors, which was formed by the consolidation of 17 autocompanies in 1908, was destined to become the largest auto producer inthe world, a title that in 2007 it still owns. And until it was surpassed byToyota in 2007, General Motors was the world leader in sales. But foreigncompetition and healthcare obligations to its retired labor force havedrained GM’s resources and reduced the creditworthiness of its oncegrade-A obligations to “junk” status. Despite its trouble, it is the largestforeign car manufacturer in China, the world’s fastest-growing automotive market. The world is waiting to see whether GM, like U.S. Steel andAT&T, can regain its predominant position in the automobile market.The returns of three—Union Carbide (now part of Dow Chemical),DuPont, and Alcoa—of the remaining four firms all belong to the materials industry and have lagged the market significantly over the past halfcentury. The fourth firm, Eastman Kodak, failed to make a successfultransition to digital photography. Unionization and foreign competitionare some reasons behind the poor performance of these firms. Whetherthese erstwhile giant corporations will be able to reinvent themselves isyet to be seen.
TOP-PERFORMING FIRMSThe 20 best-performing firms of the original S&P 500 that have survivedwith their corporate structure intact are shown in Table 4-2. Table 4-3lists the 20 best-performing firms whether they have survived intact orhave been merged into another firm.By far the best-performing stock was Philip Morris, which in 2003changed its name to Altria Group.4 Philip Morris introduced the worldto the Marlboro Man, one of the world’s most recognized icons, twoyears before the formulation of the S&P 500 Index. Marlboro cigarettessubsequently became the world’s best-selling brand and propelledPhilip Morris stock upward.The average annual return on Philip Morris over the past half century, at 19.88 percent per year, almost doubled the 10.88 percent annual4
The firm retained its ticker symbol MO, or “Big Mo,” as traders affectionately call Philip Morris.
CHAPTER 4 The S&P 500 Index
TABLE
59
4–2
The 20 Best-Performing S&P 500 Firms That Have Survived Intact, 1957 through December 2006
Rank
1957 Name
2007 Name
19572006Return
1234567891011121314151617181920
PHILIP MORRISABBOTT LABSCRANE COMERCKBRISTOL MYERSPEPSI-COLA CO.SWEETS CO OF AMER.COCA-COLA COCOLGATE-PALMOLIVEAMERICAN TOBACCOHJ HEINZ CO.PFIZERMCGRAW-HILL BOOK COSCHERINGWM WRIGLEYSCHLUMBERGERPROCTER & GAMBLEHERSHEY COKROGERMELVILLE SHOE
ALTRIA GROUPABBOTT LABSCRANE COMERCKBRISTOL-MYERS SQUIBBPEPSICO INCTOOTSIE ROLL INDSCOCA-COLA COCOLGATE-PALMOLIVEFORTUNE BRANDS INCHJ HEINZ COPFIZER INCMCGRAW-HILL COS.SCHERING-PLOUGHWRIGLEY WM JRSCHLUMBERGER LTDPROCTER & GAMBLE COHERSHEYKROGER COCVS CORP
19.88%15.86%15.47%15.43%15.43%15.40%15.12%15.05%14.99%14.92%14.48%14.48%14.31%14.22%14.15%14.06%14.05%14.02%14.01%13.85%
SectorCon. StaplesHealthcareIndustrialsHealthcareHealthcareCon. StaplesCon. StaplesCon. StaplesCon. StaplesCon. Disc.Con. StaplesHealthcareCon. Disc.HealthcareCon. StaplesEnergyCon. StaplesCon. StaplesCon. StaplesCon. Staples
return on the S&P 500 Index. This return means that $1,000 invested inPhilip Morris on March 1, 1957, would have accumulated to over $8.25million by the end of 2006, nearly 50 times the $170,000 accumulation inthe S&P 500 Index.Philip Morris’s outstanding performance does not just date frommid-century. Philip Morris was also the best-performing company since1925, the date when comprehensive returns on individual stocks werefirst compiled. From the end of 1925 through the end of 2006, Philip Morris delivered a 17.2 percent compound annual return, 7.4 percent greaterthan the market indexes. If you had invested $1,000 in this firm in 1925, itwould be worth, with dividends reinvested, almost $380 million in 2007!Philip Morris’s bounty did not extend to only its own stockholders.Philip Morris eventually became the owner of 10 other original S&P 500
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PART 1 The Verdict of History
TABLE
4–3
The 20 Best-Performing Firms of the Original S&P 500 Index, 1957 through December 2006
firms. Many investors became enormously wealthy because the sharesof their firms were exchanged with shares of successful companies suchas Philip Morris. Riding on the coattails of such winners is an unexpected gift for many stockholders.
HOW BAD NEWS FOR THE FIRM BECOMESGOOD NEWS FOR INVESTORSSome readers may be surprised that Philip Morris is a top performer forinvestors in the face of the onslaught of governmental restrictions andlegal actions that have cost the firm tens of billions of dollars and havethreatened the cigarette manufacturer with bankruptcy.
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But in the capital markets, bad news for the firm often can be goodnews for investors who hold onto the stock and reinvest their dividends.If investors become overly pessimistic about the prospects for a stock,the low price enables stockholders who reinvest their dividends to buythe company on the cheap. These reinvested dividends have turned itsstock into a pile of gold for those who stuck with Philip Morris.
TOP-PERFORMING SURVIVOR FIRMSPhilip Morris is not the only firm that has served investors well. The returnon the other 19 best-performing surviving companies has beaten the returnon the S&P 500 Index by between 3 and 5 percent per year. Of the top 20firms, 16 are dominated by two industries; consumer staples, representedby internationally well known consumer brand-name companies, andhealthcare, particularly large pharmaceutical firms.5 Hershey chocolate,Heinz ketchup, and Wrigley gum, as well as Coca-Cola and Pepsi-Cola,have built up wide brand equity and consumer trust. The four other winner stocks are Crane, a manufacturer of engineered industrials productsfounded in 1855 by Richard Crane; Fortune Brands, formerly AmericanTobacco, founded in 1910, which has since divested its tobacco holding;McGraw-Hill, a global information provider, founded by James H. McGrawin 1899 and now the owner of Standard & Poor’s; and Schlumberger, an oilservice company begun by the Frenchman Conrad Schlumberger in 1919.All these firms have, despite significant changes in the economic and political landscapes, expanded aggressively into international markets.One firm of particular note is CVS Corporation, which in 1957 entered the S&P 500 Index as Melville Shoe Corp., a company whose namewas taken from the founder, Frank Melville, who started a shoe company in 1892 and incorporated as Melville Shoe in 1922.Shoe companies have been among the worst investments over thepast century, and even Warren Buffett bemoans his purchase of DexterShoe in 1991. But Melville was fortunate enough to buy the ConsumerValue Store chain in 1969, specializing in personal health products. Thechain quickly became the most profitable division of the company, andin 1996 Melville changed its name to CVS. So a shoe manufacturer, destined to be a bad investment, turned to gold as a result of the management’s fortuitous purchase of a retail drug chain.5
About one-half of the products of Fortune Brands qualify as consumer staples, but because of itsventures in golf equipment and home improvement products, it is now classified in the consumerdiscretionary index.
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There are similar stories for firms taken from Table 4-3, which liststhe 20 best-performing stocks whether they have survived in their original corporate form or have been merged into another firm. ThatcherGlass was the second best performing of all original S&P 500 stocks behind Philip Morris and was the leading milk bottle manufacturer in theearly 1950s. But as the baby boom turned into the baby bust and glassbottles were replaced by cardboard cartons, Thatcher’s business sank.Fortunately for Thatcher shareholders, in 1966 the firm was purchasedby Rexall Drug, which became Dart Industries, which merged with Kraftin 1980 and was eventually bought by Philip Morris in 1988. An investorwho purchased 100 shares of Thatcher Glass in 1957 and reinvested thedividends would have owned 140,000 shares of Philip Morris stock,worth almost $13 million by the end of 2006!
OTHER FIRMS THAT TURNED GOLDENAs the medical, legal, and popular assault on smoking acceleratedthrough the 1980s, Philip Morris, as well as the other giant tobaccomanufacturer, RJ Reynolds, diversified into brand-name food products.In 1985 Philip Morris purchased General Food, and in 1988 it purchasedKraft Foods for $13.5 billion, which had originally been called NationalDairy Products and was an original member of the S&P 500 Index.Philip Morris completed its food acquisitions with Nabisco GroupHoldings in 2000.Nabisco Group Holdings was the company the Kohlberg KravisRoberts & Co. (KKR) spun off in 1991 after taking RJR Nabisco private in1989 for $29 billion, at that time the largest leveraged buyout in history.Under our methodology for computing long-term returns, if a firm istaken private, the cash from the buyout is assumed to be invested in anS&P 500 Index fund until the company is spun off, at which point theshares are repurchased in the new IPO.6 RJ Reynolds Tobacco Co. hadpreviously absorbed six original S&P companies: Penick & Ford, California Packing, Del Monte Foods, Cream of Wheat (purchased in 1971 byNabisco), Standard Brands, and finally National Biscuit Co. in 1985. Allthese companies became top-20 performers in large part because of theirultimate purchase by Philip Morris.Also on the list of best-performing stocks is Richardson Merrell,which was purchased by Procter & Gamble in 1985, and Flintkote, which6
If the firm remains private, the returns are assumed to accumulate at the same level as the S&P 500Index.
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was founded in 1901 and produced roofing materials. In 1980 an ownership stake was bought by Genstar, which was then absorbed by Imasco,and finally bought by British American Tobacco in 2000. The purchasewas lucky for shareholders because Flintkote went bankrupt in 2004 as aresult of asbestos litigation.Virginia Carolina Chemicals was bought by Mobil Oil, best performer of the largest 20 corporations. Houdaille Industries, founded bythe Frenchman Maurice Houdaille before World War I, was bought byKKR in 1979; at the time, it was the first leveraged buyout over $100 million. Its 17.78 percent average return from 1957 through 1979 was highenough to give the firm the twentieth position.7
OUTPERFORMANCE OF ORIGINAL S&P 500 FIRMSOne of the most remarkable aspects of these original 500 firms is that theinvestor who purchased the original portfolio of 500 stocks and neverbought any of the nearly 1,000 additional firms that have been added byStandard & Poor’s in the subsequent 50 years would have outperformedthe dynamic updated index. The return of the original 500 firms was11.72 percent versus 10.83 percent for the updated index. This annualdifference results in a 50 percent higher accumulation in the originalstocks than those updated in the index.Why did this happen? How could the new companies that fueledour economic growth and made America the preeminent economy in theworld underperform the older firms? The answer is straightforward. Although the earnings and sales of many of the new firms grew faster thanthose of the older firms, the price investors paid for these stocks wassimply too high to generate good returns.Stocks that qualify for entry into the S&P 500 Index must have sufficient market value to be among the 500 largest firms. But a marketvalue this high is often reached because of unwarranted optimism onthe part of investors. During the energy crisis of the early 1980s, firmssuch as Global Marine and Western Co. were added to the energy sector,and they subsequently went bankrupt. In fact, 12 of the 13 energy stocksthat were added to the S&P 500 Index during the late 1970s and early1980s did not subsequently match the performance of either the energysector or the S&P 500 Index.7
However, one can trace the firm further. In 1987 IDEX was formed to buy back six units ofHoudaille that had been sold to a British firm. IDEX, an acronym for Innovation, Diversification,and Excellence, has outperformed the S&P 500 Index by 1.5 percent per year, and if that return wereappended to Houdaille, its half-century return would be even higher.
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About 30 percent of the 125 firms that have been added to the technology sector of the S&P 500 Index since 1957 were added in 1999 and2000. Needless to say, most of these firms have greatly underperformedthe market. The telecommunications sector added virtually no newfirms from 1957 through the early 1990s. But in the late 1990s, firms suchas WorldCom, Global Crossing, and Quest Communications entered theindex with great fanfare, only to collapse afterward.Of all 10 industrial sectors, only the consumer discretionary sectorhas added firms that have outperformed the first firms put into theindex. This sector was dominated by the auto manufacturers (GM,Chrysler, and then Ford), their suppliers (Firestone and Goodyear), andlarge retailers, such as JCPenney and Woolworth’s.
CONCLUSIONThe superior performance of the original S&P 500 firms surprises mostinvestors. But value investors know that growth stocks often are pricedtoo high and often induce investors to pay too high a price. Profitablefirms that do not catch investors’ eyes are often underpriced. If investorsreinvest the dividends of such firms, they are buying undervaluedshares that will add significantly to their final accumulation.The study of the original 500 companies also gives you an appreciation of the dramatic changes that the U.S. economy has undergone inthe past half century. Notwithstanding, many of the top performers areproducing the same brands that they did 50 years earlier. Most have aggressively expanded their franchise internationally. Brands such asHeinz ketchup, Wrigley gum, Coca-Cola, Pepsi-Cola, and Tootsie Rollsare as profitable today as they were when these products were launched,some over a hundred years ago.But we also see that many companies make good investments bybeing merged into a stronger company. And four of the top-performingoriginal companies—Dr. Pepper, Celanese, National Can, and Flintkote—are now owned by foreign companies. In fact, it is more likely than notthat the future winners among companies that are currently Americanbased will not be headquartered in the United States. Foreign firms,clearly secondary when the S&P 500 Index was founded in 1957, are apt tobe the ultimate owners of many of today’s top firms.
5
CHAPTER
THE IMPACT OF TAXES ONSTOCK AND BOND RETURNSStocks Have the EdgeIn this world nothing is certain but death and taxes.BENJAMIN FRANKLIN1
The power to tax involves the power to destroy.JOHN MARSHALL2
For all long-term investors, there is only one objective—maximumtotal real return after taxes.JOHN TEMPLETON3
1
Letter to M. Leroy, 1789.McCulloch v. Maryland, 1819.3Excerpts from “The Templeton Touch” by William Proctor, quoted in Charles D. Ellis, ed., Classics,Homewood, Ill.: Dow Jones-Irwin, 1989, p. 738.2
65Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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PART 1 The Verdict of History
John Templeton’s objective to maximize total real return after taxes is anessential investment strategy. And stocks are very well suited to thispurpose. In contrast to fixed-income investments, both the capital gainsand now the dividends are treated favorably by the U.S. tax code. So inaddition to having superior before-tax returns, stockholders often holdan even larger after-tax advantage over bondholders.
HISTORICAL TAXES ON INCOME AND CAPITAL GAINSFigure 5-1a plots the marginal tax rate on dividend and interest incomefor investors at three income levels: the highest tax bracket, the tax ratefor real 2006 income of $150,000, and the tax rate for real income of$50,000. The tax rates on capital gains are shown in Figure 5-1b.Until the dividend tax rate reductions were put into effect in 2003,the tax rates on dividend and interest income were identical, although inthe past, small amounts of dividends were often exempt from tax. From1930 to 2003 the capital gains tax rate was generally below the dividendtax rate; then in 2003 the tax rates on qualified dividends and capitalgains were made equal. A history of the tax code applicable to stock investors is provided in the appendix at the end of this chapter.
A TOTAL AFTER-TAX RETURNS INDEXA total real returns index for stocks, bonds, bills, and gold is presented inFigure 1-4 in Chapter 1. The effect of taxes on these returns is shown inFigure 5-2.The upper line of the stock range equals the before-tax real stockreturns shown in Figure 1-4. These returns would be applicableto tax-exempt individuals or institutions.■ The lower line of the stock range in Figure 5-2 assumes that investors pay the highest tax rate on dividend, interest, and capital gains income, with no deferral of capital gains taxes.■ The shaded area shows the range of total real returns from thelowest- to the highest-taxed investor.■
These calculations include only federal taxes; no state, local, or estate taxes are considered.The difference between the before- and after-tax total returns isstriking. Total before-tax real stock returns accumulate to $755,163,while after-tax accumulation for someone in the highest bracket is about$30,018—less than 5 percent of the before-tax accumulation. Similar
CHAPTER 5 The Impact of Taxes on Stock and Bond Returns
FIGURE
5-1