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The S&P 500 as a Benchmark

George L Smyth

Last week I shared some of the thinking that went into one of my Drip selections. As a continuation of the life of a Drip, I will mention a couple of the things that I consider when selecting a company, one this week, the other next week.

When evaluating a company, I check its long-term performance and see if it has outperformed the S&P 500 Index.

Consider the following. A perfectly legitimate means of investment is to put money into an S&P 500 Index fund. This allows one to potentially grow capital at an average of 11%, the approximate market average since 1926.

But then, we are looking to do better, so it is only fitting that a company that has a habit of doing this be chosen. Obviously, if the company cannot outperform this index, then it would be better to invest in the index itself.

Comparing a company's return to that of the S&P 500 does not guarantee outperformance, but it does offer evidence that it is certainly possible. A history of overachieving past performance can give one confidence that the company will continue to do what they have done in the past. Unless something basic has happened to the company, inertia can be a powerful ally.

I agree with Tom Gardner, who wrote, "Past performance may not predict anything, but it does correlate with future success. On average, in a free-market system, isn't it true that the longer the run of triumph, the more cash a great company will store up for investments in superior future results?"

This makes sense to me, as it implies that the company with this success in the past will have the resources to better make it through the tough times. Not only that, but an accumulation of cash gives a company more choices, just as you gain more options with additional spending money. Smart choices for this cash can bring higher returns to the owners — the shareholders.

Although I used to use a 100-month chart, I now find the Fool's Quotes & Data area to be more convenient (since I'm probably already here anyway). Adjusting the option to display a decade of performance and compare it with the S&P 500 will give a quick indication of how the company has fared. Any long-term time frame can be used, though I would recommend that you apply the same metric to all companies.

All market-leading companies have good and bad periods. The way that the company deals with each situation will form their history. Over many years, the ability to move the company consistently ahead of the pack is an impressive accomplishment. A company with a superior product and superior management can do so. This is the sort of stuff of which I wish my companies to be made.