Nifty Fifty - Part II

A follow up to this post on the Nifty Fifty.

The Nifty Fifty were considered premier growth stocks back in the early 1970s. By late 1972, the valuations of these stocks became quite stretched to say the least.

So what happened if you happened to buy them near the market peak in December of 1972?

Well, in the prior post, I mentioned that the top twenty performers among the Nifty Fifty since the market peak -- from December 1972 through August 1998 -- were dominated by the likes of Philip Morris (now Altria: MO), Coca-Cola (KO), Pepsi (PEP), Procter & Gamble (PG), McDonald's (MCD), Johnson & Johnson (JNJ), and Anheuser-Busch (BUD).
(According to this AAII Journal article written in October 1998 by Professor Jeremy Siegel.)

In fact, out of the top 20 performers, fully 18 of them were either those that sell consumer goods (11) or healthcare (7) businesses.*
(Incidentally, General Electric (GE) and First National City were the two other top twenty performers.)

This despite the fact that most of them were selling at fairly extraordinary P/Es back in December of 1972. Two examples among many:

- J&J's P/E was 57.

- McDonald's P/E was 71.

In 1972, Philip Morris/Altria had a P/E of 24. Not exactly cheap and well above what I'd ever pay.

Yet, by the standards of the early 1970s, it was not expensive.

Among the Nifty Fifty, it had the best annualized returns at 18.8 percent compared to the S&P 500's 12.7 percent over the ~ 26 years.

More than a 6 percent plus annualized performance gap.

In the slightly more than 14 years since the end of that ~ 26 year period, Philip Morris/Altria's annualized total return has been a bit under 15 percent (and now sells at a forward P/E of 14 or so). Over those same 14 plus years, the S&P 500 returned roughly 4.5 percent.**

So Altria has continued to do just fine as far as absolute and relative performance goes. Less than the 18.8 percent, but actually a wider relative performance gap to the S&P 500. Though, of course, what's important is not what a stock has already done, but what it is likely to do over the next twenty or thirty years and its unique risks.

The best performing Nifty Fifty stocks (those that remain publicly traded) likely don't have future prospects that are quite as bright. Many of them remain fine businesses but, as always, the price that gets paid matters. The fact that, after paying a rich multiple, these ended up working out okay in the long run doesn't mean it's a wise way to invest.

Paying high multiples of earning like those prevalent in the Nifty Fifty era -- even for the highest quality shares -- adds plenty of unnecessary risk.

In my view, an investor should always buy shares at a sufficient discount to estimated current intrinsic value. First, estimated value is necessarily imprecise. Second, when investors pay a premium to current value, there's often a lack of downside protection against the unforeseen and unforeseeable. In other words, anyone can look back at how something already did and see that it worked out. In the real world, where judgments need to be made by an investor prospectively, the price paid should always provide a meaningful margin of safety in case things do not go as well as expected.***

To me, paying a price that hopefully will be justified someday seems likely to produce too many unattractive risk-adjusted outcomes in the long run. Better to consistently buy at a plain discount to what a good business is conservatively worth per share today.

These days, few of what remains of the top performing Nifty Fifty, as well as most other so-called "defensive stocks", seem cheap enough (to provide a margin of safety) but at least they do not have the kind of extremely high valuations they've had at times in the past. The window that opened (as a result of the financial crisis) to buy shares of high quality businesses at very attractive valuations has mostly closed.

As I said previously, what's sensible to buy at a discount to intrinsic value doesn't make sense at some materially higher valuation. Margin of safety is always all-important.

Still, it's worth considering this:

"If the business earns 6% o­n capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% o­n capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger at USC Business School in 1994

There's no shortage of high P/E stocks in today's market even if they lack a memorable name like the Nifty Fifty. These new high flyers may not have a similarly memorable name, but those who own the current crop of high multiple stocks might want to consider carefully what can be learned from the Nifty Fifty.

Adam

Long MO, KO, PEP, PG, and JNJ

Related posts:
Nifty Fifty - Nov 2012
The Cost of Complexity - Aug 2012
The Quality Enterprise, Part II - Aug 2012
The Quality Enterprise - Aug 2012
Consumer Staples: Long-term Performance, Part II - Dec 2011
Consumer Staples: Long-term Performance - Dec 2011
Grantham: What to Buy? - Aug 2011
Defensive Stocks Revisited - Mar 2011
KO and JNJ: Defensive Stocks? - Jan 2011
Altria Outperforms...Again - Oct 2010
Grantham on Quality Stocks Revisited - Jul 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - Nov 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - Apr 2009
Best and Worst Performing DJIA Stock - Apr 2009
Defensive Stocks? - Apr 2009

* From December 1972 to August 1998 according to this AAII Journal article written by Professor Jeremy Siegel. It's worth noting that some of these companies are no longer separately traded marketable stocks since, not surprisingly, there have many corporate changes to the Nifty Fifty over the years. Generally, they have either been acquired by other public companies or are now private. The article summarizes all the corporate changes that had occurred up to that point in time. 
** Through October 31st, 2012. Excluding taxes, a stock with those kind of annualized returns over 40 years (~ 26 years plus ~ 14 years) compounds in such a way that results in a nearly 600-fold increase in value. Philip Morris International (PM) has separately not done too badly either since the spin-off in 2008. That stock has had roughly 18 percent annualized returns since the spin-off
*** The discount to value should account for the many risks that exist going into an always unpredictable future. The size of the required discount necessarily varies and, for shares of many businesses, no price is cheap enough. Eventually, it's more a go/no go decision and is based upon whether the competitive advantages can be judged, with enough confidence, to be significant and durable.
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