If it was 1950, would you pick IBM or Exxon?

IMG_1194I was reading Jeremy Siegel’s book “Stocks for the Long Run” and it asked whether IBM or Standard Oil (now Exxon) would have been better investments in 1950, assuming all dividends were re-invested. From 1950-2012, IBM had better sales, earnings, dividends, and sector expansion. IBM’s earnings per share growth was more than 3% higher than Exxon’s every year for those 62 years. Technology advanced and that sector grew much more than the oil industry, which shrank over that period of time.

Both stocks did well, but Standard Oil/Exxon earned more than 1% more per year than IBM. $1,000 invested in Standard Oil would have been worth $1,620,000, more than double IBM at the end of that period of time. Granted, 62 years is far outside most investors’ timeframes. According to the author, the difference comes down to valuation, the price paid for the earnings and dividends you receive. IBM was more expensive than Standard Oil. The price/earnings ratio of Standard Oil was half that of IBM, and Standard Oil’s dividend was more than two percentage points higher.

This means that it is wise to look for both good dividends and a low P/E ratio when choosing stocks. In my holiday reading, I learned that it is best to choose stocks with a dividend yield of at least 4.7%, but also with a long term trend of growing dividends. A low P/E ratio is also important, ideally below 20 and even better if it’s lower than 15 as this suggests that the companies are not too expensive.

The rest of the book wasn’t quite as helpful to me. Surprisingly, the author leans towards low-cost stock index funds, despite the depth in which he goes in explaining the workings of the market. His lesson that value stocks (those with lower P/E ratios and higher dividend yields) have superior returns and lower risk than growth stocks was good to learn, but it was followed by the suggestion to “tilt your portfolio toward value by buying passive indexed portfolios of value stocks or, fundamentally weighted index funds.” I’m not as keen on this as I would prefer not to pay management fees and to have dividend-paying stocks with re-invested dividends. I am also trying to learn how not to be lured by stocks with high dividend yields where I get burned by both a cut in the dividend followed by a dramatic drop in the stock price. Those high-yielders can signal a value stock (which is a good thing) but so often can be a danger sign. It can be hard to distinguish.

I have long been wanting to invest in a company like Starbucks, where I see great management, a great product, good growth, and a product I really like. But it doesn’t pay a high dividend (it’s somewhere around 1.4%) and has a very high P/E ratio of around 30. Based on the IBM/Exxon example, something like Pizza Pizza, which yields over 5.5% and has a P/E of about 16 might be a better choice. Or Bank of Nova Scotia with a yield of over 5% and a P/E of about 9.5.

Michelle

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