The Best Stocks Are Historically Found in a Handful of Industries

Tobacco, Pharmaceutical, & Consumer Staples Made You Rich Over the Past 50 Years

The Best Stocks to Buy
Perhaps finding the best stocks to buy for your investment portfolio would be easier by examining the academic evidence about what successful stocks have in common. It turns out, they all cluster around industries with specific economic advantages. Roy Scott / Ikon Images / Getty Images

One of the major benefits of being an investor in the 21st century is having a couple of centuries of stock market data to examine not only in the United States but around the world.  There is some fantastic work both in the private banking sector and coming out of academia looking at what, specifically, the best stocks to buy for long-term ownership have in common.

It turns out that in this regard, the companies that make the "best of" list are not at all random.

 Certain industries have specific economic, legal, and cultural benefits that make it possible for the components within them to ​compound money at rates far above average, producing high total shareholder return even when the initial price-to-earnings ratio is not exactly cheap.  This means the highest returning stocks are clustered around a tiny portion of the overall economy, producing annual out-performance of 1% to 5%, which is a staggering wealth differential over periods of 10, 25, 50, or more years.

In this article, we're going to look at some of the findings in the hope that identifying what the best stocks to buy have been, we can better understand risk management and portfolio construction for a long-term investor.

In the United States, the Best Stocks To Buy Have Centered Around Tobacco, Pharmaceuticals, and Consumer Staples

In his best-selling book detailing why boring stocks you might find in your grandparents' portfolio are almost always more profitable than the hot issues of the day, Wharton Business School professor Dr. Jeremy J.

Siegel, whom I've written about several times in the past, researched the total accumulation of an initial $1,000 investment, with dividends reinvested, put into each of the original S&P 500 surviving firms between 1957, when the index was established, and 2003, when he began drafting his findings.

(Stocks have obviously grown in value significantly since that time so the figures would be much higher today. Nevertheless, it is still useful to look at his results.)

He then examined the top 20 firms, which represented the best stocks to buy -- the top 4% of the original S&P 500 -- if you had perfect hindsight to try and figure out what made them so different. You might expect with so many different kinds of companies operating at the time, you'd have ended up with businesses ranging from railroads to cruise ship operators.  Nothing could be further from the truth.  To put it in real-world terms, between 1957 and 2003, an initial stake of $1,000 ultimately turned into:

  1. Philip Morris - Tobacco - $4,626,402 - 19.75% CAGR
  2. Abbott Labs - Pharmaceuticals - $1,281,335 - 16.51% CAGR
  3. Bristol-Myers Squibb - Pharmaceuticals - $1,209,445 - 16.36% CAGR
  4. Tootsie Roll Industries - Consumer Staples - $1,090,955 - 16.11% CAGR
  5. Pfizer - Pharmaceuticals - $1,054,823 - 16.03% CAGR
  6. Coca-Cola - Consumer Staples - $1,051,646 - 16.02% CAGR
  7. Merck - Pharmaceuticals - $1,003,410 - 15.90% CAGR
  8. PepsiCo - Consumer Staples - $866,068 - 15.54% CAGR
  9. Colgate-Palmolive - Consumer Staples - $761,163 - 15.22% CAGR
  10. Crane - Industrial - $736,796 - 15.14%
  1. H.J. Heinz - Consumer Staples - $635,988 - 14.78% CAGR
  2. Wrigley - Consumer Staples - $603,877 - 14.65% CAGR
  3. Fortune Brands - Tobacco and Consumer Staples - $580,025 - 14.55% CAGR
  4. Kroger - Retail - $546,793 - 14.41% CAGR
  5. Schering-Plough - Pharmaceuticals - $537,050 - 14.36% CAGR
  6. Procter & Gamble - Consumer Staples - $513,752 - 14.26% CAGR
  7. Hershey - Consumer Staples - $507,001 - 14.22% CAGR
  8. Wyeth - Pharmaceuticals - $461,186 - 13.99%
  9. Royal Dutch Petroleum - Oil - $398,837 - 13.64%
  10. General Mills - Consumer Staples - $388,425 - 13.58% CAGR

This means that 18 of the top 20 performing original S&P 500 components, or 90%, came from three narrow parts of the overall economy: Tobacco, Consumer Staples, and Pharmaceuticals.  That is statistically relevant.

What makes this possible? Tobacco was an interesting case of combining extreme pricing power, massive returns on capital, an addictive product, and share prices being driven down by the war the Federal and state governments waged on the firms, along with the perceived evil of the businesses (in my own family, no matter how cheap tobacco stocks get from time to time, certain members will not allow me to add any to their portfolios).

Perpetually undervalued, owners who plowed back their dividends into more stock accumulated additional shares at a rapid rate decade after decade, enriched by the fact these extremely profitable firms were unpopular for social reasons. (In the United Kingdom, alcohol was the equivalent, crushing everything else. It very well may have been in the United States but we'll never know due to prohibition altering the landscape of the industry.)

Consumer staples and pharmaceuticals, on the other hand, tended to enjoy several major advantages inherent to the business model that make them ideal compounding machines:

  • The best stocks to buy create a product that nobody else can legally produce then delivers that product using super efficient distribution channels. This results in hard-to-replicate economies of scale. The product is protected by trademarks, patents, and copyrights, allowing the company to price higher than it otherwise could, accelerating the virtuous cycle as it generates higher free cash flow that can then be used for advertising, marketing, rebates, and promotions. Most people don't reach for the knockoff Hershey bar or Coca-Cola bottle. They want the real thing, with the price differential being small enough there is no utility trade-off on a per-transaction basis.
  • The best stocks to buy have strong balance sheets that allow them to weather nearly every sort of economic storm imaginable.  This lowers their overall cost of capital.
  • The best stocks to buy generate a much higher-than-average return on capital employed, as well as return on equity.
  • The best stocks to buy disproportionately have a history of paying ever-growing dividends, which imposes capital discipline on management. Though it's not foolproof, it's a lot harder to overspend on expensive acquisitions or executive perks when you have to send at least half the money out the door to the owners each quarter.  In fact, on a market-level analysis basis, the relationship is so clear you can divide all stocks into quintiles and accurately predict total return based on dividend yields.  (This correlation is so powerful, dividend growth stocks as a class make better-than-average buy-and-hold investments.)
  • On top of all of these characteristics (and only when the others are present), the best stocks to buy often have near complete control of their respective market share or, at worst, operate as part of a duopoly or triumvirate.

Interestingly, several of the top 20 stocks on that list have since merged into even stronger, more profitable firms. This should reinforce their advantages going forward:

  • Philip Morris spun-off its Kraft Foods division, which then broke itself apart into two companies. One of those companies, Kraft Foods Group, announced a couple of days ago it is consolidating with H.J. Heinz.  The new business will be called Kraft-Heinz.
  • Wyeth was acquired by Pfizer.
  • Schering-Plough and Merck merged, taking the latter's name.

Just as interestingly, many of these businesses were already giant, household names back in the 1950's. Coke and Pepsi between them held a super-monopoly on all market share in the carbonated beverage category. Procter & Gamble and Colgate-Palmolive controlled the aisles of grocery stores, general stores, and other retail shops.  Hershey, Tootsie Roll, and Wrigley, along with the privately held Mars Candy, were titans in their respective field, long having established dominance in their respect corner of the confectionery, chocolate, candy, and gum industries. Royal Dutch was one of the biggest oil companies on the planet. (Side note: The other oil giants also did very, very well but fell just short of the top 20. Suffice it to say, you still would have built a lot of wealth had you owned them.)  H.J. Heinz had been the ketchup king since the 1800's with no serious competitor in sight.  Philip Morris, with its Marlboro cigarettes, and Fortune Brands (then known as American Tobacco), with its Lucky Strike cigarettes, were enormous. Everybody in the country who paid attention knew they printed money.

These were not risk-it-all-on-a-startup enterprises.  These were not initial public offerings that were being bid up by overexcited speculators.  These were real companies, making real money, often having been in business for what was then between 75 and 150 years. Pfizer was founded in 1849. Merck was founded in 1891 as a subsidiary of German giant Merck, which itself was founded in 1668. Heinz had been in business since 1869, selling baked beans, sweet pickles, and ketchup to the masses. Hershey began its corporate life in 1894; PepsiCo in 1893; Coca-Cola in 1886; Colgate-Palmolive in 1806. You did not have to dig deep into the over-the-counter listings to find them, these were companies that practically everyone alive in the United States knew and patronized either directly or indirectly.  They were written about in The New York Times. They ran national television, radio, and magazine ads.

Many Other of the Best Stocks to Buy Weren't Included in the List Due to Buyouts and Timing Differences But Had Near Identical Economic Characteristics

Note that this list was restricted to original members of the S&P 500 that still survived as public businesses when Siegel wrote his research.  When you look at other top-performing companies over the past few generations that aren't on that particular roster, some of them were also extremely lucrative and could have been included if the methodology had been slightly altered.  Part of the reason they weren't had to do with the weird rules S&P employed at the time of establishment.  Originally, it could only hold 425 industrials, 60 utilities, and 15 railroads.  Entire areas of the economy were shut-out, including financial and bank stocks, which wouldn't be included in the stock market index for another couple of decades!  That means, sometimes, a great business everybody knew and that made a lot of money was left off the list to fill the quota elsewhere.  A lot of very profitable businesses were also taken private before the 2003 end date in Siegel's research, therefore being de facto removed from consideration.

Let's use Clorox as an illustration.  The bleach giant is economically similar to the other high-compounding firms - there weren't a lot of large consumer staples businesses in operation at the time and nearly every family in the United States knew of, or used, Clorox products - but it was bought by Procter & Gamble in 1957.  After a 10-year anti-trust battle, the Supreme Court ordered it spun-off as an independent business in 1967. On January 1st, 1969, it became a stand-alone, publicly traded business, again.  Someone who bought shares of the bleach maker would have knocked it out of the park, utterly destroying the broader stock market alongside its consumer staples peer group and landed on this list had it not been out of reach for that first twelve years. Clorox is so breathtakingly beautiful that around the time I was born in the early 1980's the stock was at around $1 per share in split-adjusted terms. Today, it's at $110+ per share and you'd have collected another $31+ per share in cash dividends along the way for a grand total $141+. To repeat a sentiment I've shared often, you'll never hear about it at a cocktail party. Despite 141-to-1 payoffs, people just don't care because it took nearly 35 years to achieve it. They want horse races and instant riches. Planting the financial equivalent of oak trees just isn't their style.

Likewise, McCormick, which had been around since 1889 and was the undisputed king of the American spice market, wasn't added to the S&P 500 until -- brace yourself for this -- the year 2010. Thus, despite its incredible performance and possessing nearly identical economic characteristics as the other winning enterprises -- huge returns on capital, household name recognition, market share so large you'd do a double-take, a strong balance sheet, trademarks, patents, and copyrights, global distribution that gave it a huge cost advantage - it wasn't eligible for inclusion. The sad result of this is that its super-compounding isn't found among this data set.

Look at both Dr. Pepper and Royal Crown, two soda competitors to Coca-Cola and PepsiCo.  Royal Crown went private in 1984 but you would have compounded your money at 14.14% up through that point (see page 268, Appendix, Jeremy Siegel, The Future for Investors).  Dr. Pepper was the 4th highest returning original S&P 500 member at a whopping 18.07% compounded as it was ultimately taken over by Cadbury-Schweppes.  It has since been re-spun out as a stand-alone business and continued its skyward climb nearly three-quarters of a century later.

Right about now, you may be wondering why technology stocks haven't made the list.  Unlike industries such as consumer staples, where a majority of the leading companies compounded at either satisfactory or very high, rates, technology is a hit-or-miss area.  An incredibly profitable enterprise, like MySpace, can fall apart overnight as it loses out to the new kid on the block, Facebook.  On top of this, there is a clear, academically-identified trend of investors paying too much for their tech stocks,  resulting in sub-par returns for certain firms at certain times.  Witness the dot-com bubble when the Nasdaq went from its peak of 5,046.85 (it actually reached 5,132.52 intra-day on March 10, 2000) to an unthinkable bottom of 1,114.11 on October 9th, 2002.  It took 15 years, until March of 2015, for the 5,000 mark to be reached, again.  Even worse, the NASDAQ, unlike the other stock market indices, has a lower-than-average dividend yield, meaning the total return was abysmal.

Investing in technology requires being smart and somewhat lucky. As a group, the probability of any one firm doing well is much lower than it is for the soda, candy bar, bleach, and dish soap companies that have been in business spanning three different centuries and hardly ever change. Yet, if you find an incredible opportunity that goes right, such as Microsoft, even a small position can change your life forever. Imagine you weren't fortune enough to get your hands on any of the shares in the IPO but right before the close of the market on March 13, 1986, you bought $1,000 worth of the stock. How much would you have today?  Assuming no dividend reinvestment, 29 years later in 2015, you'd have $421,582 worth of stock and $102,572 worth of cash dividends piled up for a grand total of $524,154. It took less than 30 years to beat some of the top performing stocks of the original S&P over much, much longer time horizons. That is the promise that lures people into technology stocks.

Most of the Worst Stocks to Buy Had Similar Characteristics

Now that we've talked about the best stocks to buy, historically, what about the opposite end of the spectrum?  When you survey the wreckage of the companies that went bust or returned very little over inflation and taxes, patterns also emerge. Though there are always firm-specific risks where good companies are taken down by mismanagement (e.g., AIG, Lehman Brothers), you can't predict that sort of thing.  Here, we're talking about structural issues in certain industries that make those industries, as a whole, extremely unattractive on a long-term basis.  Not every type of business can become a buy-and-hold investment but these bad businesses can make good stock trades.  These sub-par companies frequently:

  • Have huge capital outlay requirements that put them at enormous disadvantages in inflationary environments
  • Have a fixed cost operating model that involves a lot of baseline expenses that need to be paid regardless of revenue levels
  • Have little to no pricing power, often competing on the basis of price along with competitors who are in the same boat. This leads to a race-to-the-bottom and an inevitable fight-for-survival.  In some cases, the cycle of prosperity-struggle-bankruptcy court repeats itself over and over, again, every decade or so.
  • Generate low operating profit per employee combined with high-skill employee requirements that give the workforce the ability to unionize or avoid automation, taking a larger share of the paltry returns
  • Are subject to booms-and-busts
  • Are vulnerable to changes in technology

Whereas the best stocks to buy are made up disproportionately of consumer staples, pharmaceuticals, and tobacco firms, the worst stocks to buy are over-represented by steel mills, aluminum, airlines, and shipbuilders.

There's also a quirk that might serve as a warning for those who worry about the long arm of both radical communism and government policy: Sugar makers and refineries. Why? When Cuba fell to the communist, many sugar fields and factories were lost. Later, the U.S. Government, at the behest of a billionaire sugar family, implemented tariffs making it too expensive to import cane sugar and make money. For awhile, back in the 1980's, Wall Street thought beets grown in New England might be the solution, replacing beet sugar with cane sugar. It didn't work. Fast forward and the corn farmers in Iowa got politicians to bribe them with farm subsidies in exchange for backing during the Presidential election primaries, leading to a situation where corn is artificially cheap. This abundance caused high fructose corn syrup to proliferate as it was much less expensive. Along with other relevant variables, these forces conspired to wreck the sugar industry, which, unlike tobacco, had absolutely zero pricing power (sugar is sugar -- if it's white and tastes sweet, you likely don't care which you put in your tea or cake). Practically all firms in the space that had once been part of the S&P 500 went bust. Vertientes-Camaguey Sugar. Manati Sugar. Holly Sugar. Imperial Sugar. Guantanamo Sugar. Bankruptcy, all. Other firms, like Great Western Sugar, ended up compounding at 3.6% for owners, not even keeping pace with inflation.

Attempting to Identify the Best Stocks to Buy for the Next 50 Years

The odds are good that, like most people, you won't be able to identify the next Microsoft or Apple.  In that regard, the best predictor of the future is the past.  The same economic forces that make some companies so profitable and cause others to struggle still remain largely identical to what they were in 1957 when the original S&P 500 was published.  Highly lucrative, household-name companies that dominate their market share and are not subject to technological displacement to the degree other firms are still appear to be the perfect risk-reward trade-off.  It may take you longer to get rich, but by patiently dollar cost averaging into these top-shelf firms over many decades, you just may turn into one of those secret millionaires who leaves behind a fortune, like Ronald Read, the janitor who passed away last year.  His heirs discovered a five-inch-thick pile of stock certificates in a bank vault. Those and some of his direct stock purchase plans were ultimately valued at more than $8,000,000.