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Financial Literacy

The “Wizard of Wharton’s” Favorite Ratio for Evaluating Stocks

Three weeks ago, Alexander Green reminded us that stocks beat gold, bonds and real estate as the ultimate inflation hedge. Friday, the “Wizard of Wharton” presented yet another batch of proof…

Jeremy Siegel is a professor of finance at the Wharton School of the University of Pennsylvania. He’s also the author of two books, “The Future for Investors” and “Stocks for the Long Run,” which The Washington Post named one of the “10 best investment books of all time.”

He appears frequently on CNBC and other networks, besides writing regularly for Kiplinger’s, The Wall Street Journal, Barron’s and The Financial Times.

Last week at FreedomFest, Siegel lectured about the economy and the financial markets. His comments reinvigorated my confidence in America’s future and our stock markets…

The Wizard of Wharton’s Best Investment

The “Wizard of Wharton’s” message was loud and clear: “Stocks remain your best investment for the long run. Neither bonds nor gold can match stocks if you have an adequate time horizon.” Given the bank and mortgage defaults and the depressing results of stocks this summer, his message was reassuring and full of optimism.

Jeremy Siegel’s findings, which are the product of years of academic research, captivated the audience. Take a look at some returns that caught my eye…

Jeremy Siegel's findings on stock returns

His research proves that over time, stocks are a superior investment to all other asset classes. Over the long term, stocks have returned 6.8% per year after inflation. Whereas gold has returned -0.4% (failing to keep up with inflation) and bonds have only a 1.7% return. After taxes, the outperformance of stocks is even greater.

Siegel’s Favorite Ratio for Evaluating Stocks

Professor Siegel said that his favorite ratio for evaluating stocks is the expected rate of return. He calculated this with the formula 1/PE (Price to Earnings Ratio). For example, with General Electric (NYSE: GE) trading at a PE of 12.78, the expected return would be 1/12.78, or a 7.8% return.

Moreover, Siegel suggested buying high-dividend-yielding stocks. His research shows that much of the returns of the market are the result of compounding dividends. His example of a quality dividend paying stock was Philip Morris (NYSE: MO). It was an original member of the S&P 500 when it was created in 1957. And it’s the best performing stock in the index since inception…

Thirty-three shares of Phillip Morris, bought in 1957 would be worth $8 million today. It goes to show the power of dividend reinvestment.

  • He argued that given a sufficiently long period, stocks are less risky than bonds.
  • After a holding period of 10 years, the worst performance for stocks was -4.1%, and -5.4% for bonds.
  • With a holding period of 20 years, stocks have never lost money according to his calculations.

So as the major indexes continue to touch multiyear lows, hang tight. No one can tell you when stocks will move higher again, at least not with precision. But history shows us it will indeed happen.

In the meantime, just be sure to mind your trailing stops to protect your wealth.

Good investing,

Floyd

Today’s Investment U Crib Sheet

Here are a handful of developments putting short-term pressure on stocks right now…

  • Microsoft (NYSE: MSFT) and Yahoo! (NYSE: YHOO) exchanged barbs this week. Activist shareholder Carl Icahn is complicating takeover negotiations between the two companies. Icahn wants to remove the Yahoo! board and replace it with one of his choosing to facilitate a sale to Microsoft. Yahoo! rejected Microsoft’s last offer amid fears that the sale would break Yahoo! into smaller pieces.
  • On Friday, the Federal Deposit Insurance Corporation took control of Indymac Bank (NYSE: IMB). Mortgage defaults severely hurt IndyMac, jeopardizing its financial stability. This drove many customers to withdraw their funds. Deposits are insured and guaranteed by the FDIC up to $100,000. Customers with larger amounts may have to accept partial payments for their assets.
  • Congress is debating the details of a rescue plan for Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM). As the largest home guarantors in the country, they handle close to $5 trillion in home loans. That represents about half of the nation’s mortgages. The debate rages on Capital Hill over the backing of these companies by the U.S. government from U.S. Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke.
  • General Motors (NYSE: GM) announced that it would suspend its dividend, cut its salaried worker costs by 20% and raise $15 billion to shore up its financial position. The company is switching its manufacturing facilities over to smaller, more gas-thrifty vehicles. GM is the worst performing Dow 30 component over the last 12 months.

The mortgage fallout is forcing many banks to cut their dividends. Here are several warning signs that could tip you off beforehand… and one bank stock you should avoid in Investment U Issue #816, As Bank Stocks Fall… Beware of the Dividend Trap.


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