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"Past performance is not an indication of future results". How many times have investors been reminded of this fact? And yet, many of us choose our stocks and mutual funds based on how they have performed over the past 3, 5, and 10 year periods. Are we all using the wrong logic in picking our stocks? That depends on if future prospects will resemble past ones. In his book, The Future for Investors, Jeremy Siegel, a Wharton professor, examines what the future is likely to hold for investors, and what the best investment strategies are for taking advantage.

The Future for Investors is, in essence, a 2 part book (although the two parts are interleaved with each other throughout). The first part examines what has worked best in the past, and the second part examines the coming "age wave" and how the growth of emerging economies are critical to avoiding steep drops in stock prices.

Siegel first examines which investments have performed the best since the formation of the S&P 500 in the late 1950's. In a surprising finding, the original S&P 500 stocks outperformed the new companies that were added to the index, primarily due to the compounding of reinvested dividends. The best performing stock of the last 50 years was Altria Group (MO), formerly Philip Morris, with nearly 20% annual returns. The primary reason for this was dividend reinvestment. Philip Morris has never lowered it's dividend, and usually raised it, but the wildly fluctuating stock price led to the accumulation of large quantities of MO stock (when the price was low, the dividend purchased more shares through reinvestment). In all, the best performing 20 companies of the original S&P 500 were almost all from one of three sectors - consumer staples, branded pharmaceuticals, and energy.

Two interesting concepts are also explained in the book: the "Growth Trap" and the "Basic Principle of Investor Returns". These are, in fact, related concepts. The Basic Principle of Investor Returns states that the return on investment is related not just to the stock's earnings growth rate, but to the growth rate relative to expectations. Ignoring this principle leads investors into the "Growth Trap", where they pay too much for growth and experience lower returns. He illustrates this by comparing the returns of Exxonmobil (XOM) and IBM (IBM) since 1957 (Exxon wins despite much lower earnings and revenue growth), and by showing just what kind of growth AOL (TWX) or Cisco (CSCO) would have had to achieve to justify their 100-plus P/E ratios during the tech boom of 1999-2000.

Siegel's conclusion to the first question, what investment strategies will work well in the future, is useful. He discusses historically successful, dividend based strategies such as the Dow 10 ("Dogs of the Dow"), the related S&P 10 strategy, consumer staples/branded pharma/energy sectors, and S&P 500 survivors.

The second part of the book talks about demographics and the future they will play in asset prices. Frankly, I find this part of the book quite abstract and theoretical (Siegel had me laughing out loud with the words "I built a model of the world economy"). The gist is this - the retirement of the baby boomers in the U.S., Europe, and Japan will lead to a wave of stock and bond sales to fund retirements, and there are not enough working age people to purchase these assets. Since supply will far exceed demand, prices will plummet, and stock returns will be abysmal going forward. However, Siegel "has found the solution" to the problem. Younger nations such as China and India, through economic development, will purchase these assets and everything will be A-OK.

Obviously, this is a pretty simplistic view of the future. Siegel does not mention the very high possiblity that many boomers may not sell all of their assets, and in fact will likely bequest a large portion of them, allowing the government to destroy the wealth instead.

So, how does this book relate to the Magic Formula? First of all, it shows how following the Magic Formula screen can save you from a lot of common investment mistakes, in this case the "Growth Trap". Also, I'm a firm believer in combining the precepts of successful strategies. In fact, I consider Dow 10 and other value and historical based strategies when looking for Top Buys in the MFI screen. Last, the "Basic Principle of Investor Returns" helps to explain why the Magic Formula works. These are all stocks with very low expectations. The bar is set very low, so even minuscule growth can lead to big returns for investors. Compare this to growth stocks that can deliver 25% earnings gains and still lose money for their stockholders.

Disclosure: Steve owns CSCO

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