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Growth Stocks, Stunted Gains?

By Amey Stone Wharton professor Jeremy Siegel's Stocks for the Long Run hit the bookstores in 1994, just as that decade's bull market was starting to roar. It quickly became a best seller. Today it's regarded as one of the classic texts of growth-stock investing, much the way Benjamin Graham and David Dodd's 1940 Security Analysis, became the bible for value investors.

Now Siegel has a follow-up, called The Future for Investors. And his growth-stock fans aren't going to be too happy with some of his assertions.

STRONG ORIGINALS. A major premise of the new book is that investing in the stocks of the fastest-growing companies is a bad idea (see a video interview with Siegel). The simple reason is that investors too often overpay for growth.

"Growth is not the problem, it's what people are paying for growth," he explained in an interview with BusinessWeek editors in advance of publication (the official release date is Mar. 8). Investors would do better buying out-of-favor industries, reinvesting often-high dividends so as to accumulate more shares in weak periods, and waiting until those companies return to favor. Only then might they have a shot at outperforming the 5% to 7% returns he expects for the market over the next 15 or 20 years.

In the first part of his book, titled "Uncovering the Growth Trap," Siegel painstakingly shows, using reams of data, that a negative correlation exists between growth and investment results. Exhibit No. 1: He found that anyone who had bought and held the original 500 stocks in the Standard & Poor's 500-stock index when it was created in 1957 would have made more money than someone who owned the updated index over that time. (The S&P 500 is reformulated by committee periodically to make sure it encompasses the 500 leading companies.)

WEST-TO-EAST SHIFT. When he started his research, Siegel admits he thought that rejuvenating the list with the fastest growers was one reason it performed so well. Not so, it turns out. "I found that astounding," he admits.

Siegel didn't set out to write a downbeat book. His goal was to answer two questions not answered by the first book. First, which stocks should investors buy for the long haul? And second, what's going to happen when all the baby boomers retire?

The second half of his book deals with the aging crisis and the global shift in economic power from the West to East (mainly China and India). Those questions might seem headed toward gloomy conclusions, too, yet here Siegel is surprisingly reassuring.

REINVEST YOUR DIVIDENDS. He thinks that as global capital shifts, investors in developing countries will buy U.S. assets, keeping domestic stock prices afloat, even if the mass of baby boomers all decide to sell at the same time. IBM's (IBM) sale of its computer division to Chinese-owned Lenovo Group and Mittal Steel's purchase of International Steel Group (ISG) are two examples of the start of this asset shift, he believes.

Ultimately, Siegel still affirms that stocks (especially value-oriented ones) are still the best long-term investments. Even better, at a current price-earnings ratio of 18 to 20 times earnings, he doesn't think they're badly overpriced. Whew!

Still, to outperform the modest returns he expects for the broad market, he suggests:

1. Invest 60% of your stock portfolio in the U.S. and 40% in companies based overseas (in his earlier book he recommended a 25% foreign allocation).

2. Index half of your portfolio. For the U.S. portion, look for a fund that replicates the Wilshire 5000 Index, which includes nearly all publicly traded companies, small-cap as well as large-cap. For the international portion, invest in the benchmark international EAFE index (Europe, Australia, Asia, and the Far East).

3. With the remaining 50% of assets, stay broadly diversified, but emphasize stocks with high dividends selling for low price-earnings ratios.

4. Tilt toward industries that have performed the best over time, including brand-name consumer staples, pharmaceuticals, and energy stocks.

5. Without fail, reinvest your dividends.

Will Siegel's advice this decade be is as sentient as it was in the 1990s? We'll see. But his track record makes him worth paying attention to in uncertain times. Stone is a senior writer for BusinessWeek Online in New York

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