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. As a result, we know a lot about which stocks are best to buy for long-term ownership—and what those stocks have in common.
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. These companies produce 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.
- There are three industries that have been the most successful for investors.
- The best industries to invest in might change over time, but the companies that have and keep a competitive advantage will continue to be great investments.
- Long histories, strong balance sheets, and a history of dividends make companies good investments.
- The best stocks to buy will not offer immediate returns but take decades to grow.
The Benefits of Boring Stocks
In his bestselling book, "The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New," Wharton professor Jeremy J. Siegal detailed why boring stocks you might find in your grandparents' portfolio are almost always more profitable than the hot issues of the day.
Siegel 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.)
Then, Siegel examined the top 20 firms, which represented the best stocks to buy—the top 4% of the original S&P 500—to try and figure out what made them so different.
The Best Stocks to Buy Are in 3 Industries
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.
Between 1957 and 2003, an initial stake of $1,000 ultimately turned into:
- Philip Morris - Tobacco - $4,626,402 - 19.75% CAGR
- Abbott Labs - Pharmaceuticals - $1,281,335 - 16.51% CAGR
- Bristol-Myers Squibb - Pharmaceuticals - $1,209,445 - 16.36% CAGR
- Tootsie Roll Industries - Consumer Staples - $1,090,955 - 16.11% CAGR
- Pfizer - Pharmaceuticals - $1,054,823 - 16.03% CAGR
- Coca-Cola - Consumer Staples - $1,051,646 - 16.02% CAGR
- Merck - Pharmaceuticals - $1,003,410 - 15.90% CAGR
- PepsiCo - Consumer Staples - $866,068 - 15.54% CAGR
- Colgate-Palmolive - Consumer Staples - $761,163 - 15.22% CAGR
- Crane - Industrial - $736,796 - 15.14%
- H.J. Heinz - Consumer Staples - $635,988 - 14.78% CAGR
- Wrigley - Consumer Staples - $603,877 - 14.65% CAGR
- Fortune Brands - Tobacco and Consumer Staples - $580,025 - 14.55% CAGR
- Kroger - Retail - $546,793 - 14.41% CAGR
- Schering-Plough - Pharmaceuticals - $537,050 - 14.36% CAGR
- Procter & Gamble - Consumer Staples - $513,752 - 14.26% CAGR
- Hershey - Consumer Staples - $507,001 - 14.22% CAGR
- Wyeth - Pharmaceuticals - $461,186 - 13.99%
- Royal Dutch Petroleum - Oil - $398,837 - 13.64%
- 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.
Why Are These Sectors Successful?
These sectors have done well for several reasons. First, consumer staples and pharmaceuticals tend to enjoy several major advantages inherent to the business model that make them ideal compounding machines.
Second, tobacco combines factors such as extreme pricing power, massive returns on capital, and an addictive product. Add to that the fact that share prices have been driven down by the perceived evil of the businesses.
In the United Kingdom, alcohol was the equivalent, crushing everything else. It may have been in the United States as well, but we'll never know due to prohibition altering the industry's landscape.
What the Best Stocks Have in Common
The best stocks are companies that create a product that nobody else can legally produce then deliver 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. This allows the company to price higher than it otherwise could, accelerating the virtuous cycle. This 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—since the price differential is small enough, there is no utility trade-off on a per-transaction basis.
In addition, the best stocks:
Have Strong Balance Sheets
The best stocks have strong balance sheets that allow them to weather nearly every sort of economic storm imaginable. This lowers their overall cost of capital.
Offer High Returns
These stocks generate a much higher-than-average return on capital employed, as well as return on equity.
The best stocks 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 spend 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, the best stocks often have near-complete control of their respective market share or, at worst, operate as part of a duopoly or triumvirate.
A Note About Mergers
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, consolidated with H.J. Heinz, becoming The Kraft Heinz Company.
- Wyeth was acquired by Pfizer.
- Schering-Plough and Merck merged, taking the latter's name.
Companies With a Long History
Just as interestingly, many of these businesses were already giant, household names back in the 1950s.
- Coke and Pepsi 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 fields, long having established dominance in their respective corner of the confectionery, chocolate, candy, and gum industries.
- Royal Dutch was one of the biggest oil companies on the planet.
- H.J. Heinz had been the ketchup king since the 1800s 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. They were not initial public offerings that were bid up by overexcited speculators. Instead, these were real companies. They made real money, and most had been in business for between 75 and 150 years at that time.
You did not have to dig deep into the over-the-counter listings to find them. These were companies that practically everyone 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.
Why Some of the Best Stocks Are Missing
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, the index 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. In addition, many very profitable businesses were taken private before the 2003 end date of Siegel's research and were therefore removed from consideration.
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), it's impossible to 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.
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
The worst stocks to buy are over-represented by steel mills, aluminum, airlines, and shipbuilders.
The Best Stocks to Buy for the Next 50 Years
The odds are that you won't be able to identify the next Microsoft or Apple.
However, 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 those of 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 still appear to be the perfect risk-reward tradeoff.
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.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.