The Economist's Phenomenon
By Tom Dyson
September 21, 2007

Jeremy Siegel is a famous economist from the Wharton School of Business.

In 2001, the so-called "Wizard of Wharton" was reading a book on stock returns published by two Wall Street executives. The book claimed that focusing on high-flying stocks is the best way to beat the market. Although it was a bestseller, Siegel knew the book's conclusion was totally wrong... and decided to prove it.

He collected reams of stock data, employed the top IT students at Wharton to manage the data, and then published his research in a book called The Future For Investors.

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Here's the thing... In rebutting these two Wall Street partners, Siegel stumbled upon an amazing phenomenon in the data... almost by accident. Siegel's discovery can help investors like us identify the best long-term buy-and-hold stocks in America over the next 50 years.

In fact, a portfolio of the 10 best buy-and-hold stock investments in America, based on Siegel's discovery, would have turned $1,000 into approximately $1.9 million over the last 50 years.

Here's what happened:

Every year, the administrators of the S&P 500 kick out several old companies and replace them with an equal number of new companies. This annual rebalance makes sure the S&P 500 index represents the leading companies in the U.S. economy.

In their book, Creative Destruction: Why Companies That Are Built to Last Underperform the Market – and How to Successfully Transform Them, two partners with the Wall Street firm McKinsey & Co. concluded that replacing turtles with hares every year is the reason the S&P index generates such strong annual returns.

This would seem to make sense. New economy stocks grow faster than metal benders, so they should add more juice to the S&P's returns. The book raced up the bestseller lists.

"If today's S&P 500 were made up of only those companies that were on the list when it was formed in 1957... the overall performance of the S&P would have been about 20% less per year than it actually has been."

This analysis disturbed Siegel. If true, then all you'd have to do to beat the market would be buy the newest stocks and sell the old ones. But that couldn't possibly be true, otherwise everyone could beat the market.

To prove them wrong, Siegel compared the performance of the original S&P firms, tracking all their spin-offs, stock distributions, and mergers to the performance of the replenished S&P index, as you and I know it.

Here's what he found:

If you'd bought the 500 original stocks in the S&P in 1957 and held them until today, you'd have made an average 11.3% per year.

If you had bought the S&P 500 index in 1957, you'd have made an average 10.85% per year.

Half a percent may not seem like much, but over 50 years it increases the return on a $1,000 investment by $38,733. More importantly, it solves the argument.

"The shares of the original S&P 500 firms have," says Siegel, "on average, outperformed the nearly 1,000 new firms that have been added to the index over the subsequent half century." Siegel calls this dominance the "Triumph of the Tried and True."

How could this be possible, you ask?

The answer is simple... The old stocks performed better for investors because they didn't have such high expectations built into their share prices. So even though they didn't grow as fast as the new additions, they generated higher returns.

Where did the McKinsey partners go wrong?

They used changes in market cap to calculate stock returns, not the true investment returns you get from adding stock price movements with dividends.

What does this mean for us?

This is fantastic news. We don't have to break our backs trying to predict the next best thing because – according to Siegel's research – we'll make better returns by simply buying what's worked in the past.

Of the original stocks in the S&P 500, these 20 stocks performed best over the last 50 years. Siegel calls them his Corporate El Dorados.

Look how the drug companies dominate this list (along with consumer brand-name stocks). Only six pharma stocks survive today in their original form, and all six made it into the top 20 best performers. This is Siegel's "phenomenon."

"As long as firms in the sector do not stray too far from their historical average," concludes Siegel, "firms in healthcare are likely to outperform the market over the next fifty years..."

My conclusion: For consistent long-term buy-and-hold returns and consistent dividend payments, own a blue-chip pharmaceutical stock. They have beaten the market over long time periods. This will probably continue.

Good investing,