Thursday, November 1, 2012

Nifty Fifty

The Nifty Fifty were considered the premier growth stocks back in the early 1970s.

"The Nifty Fifty were often called one-decision stocks: buy and never sell. Because their prospects were so bright, many analysts claimed that the only direction they could go was up. Since they had made so many rich, few if any investors could fault a money manager for buying them.

At the time, many investors did not seem to find 50, 80 or even 100 times earnings at all an unreasonable price to pay for the world's preeminent growth companies." - Professor Jeremy Siegel in an October 1998 AAII Journal article

Basically, As a group these fifty stocks sold for an average P/E of 41.9 in December of 1972. At the time, the S&P 500 had a P/E of 18.9.*

Professor Siegel compared the returns of these stocks from the market peak in December 1972 through August of 1998.

In some ways, the thinking an investor could pay such high multiples seems not completely flawed. Well, at least at first glance. Over that slightly less than 26 year period, the total return of these fifty stocks (bought at the peak), as a group, ended up being 12.2 percent while the S&P 500 returned 12.7 percent.

So some might conclude that the higher multiples proved to be at least somewhat justified.

There are, I think, some real problems with this point of view.

Even though it worked out okay in the long run, an investor who paid those high multiples had little margin of safety to protect against unforeseen outcomes. It's one thing to look at results after the outcome is certain. It's another thing altogether to pay such a high price going into an unpredictable future. Minimizing the possibility of permanent capital loss is all-important. Practically speaking, an investor needs a sufficient margin of safety when they buy shares of even the best enterprises. Some still argue that an investor should pay up for growth and occasionally it turns out to even work. Yet, if anything, it's probably better to pay a slightly higher (but still a discount to intrinsic value...just maybe a somewhat smaller discount) multiple for those businesses with the clearest durable competitive advantages even if more modest growth prospects.

Durable and attractive core business economics matters more than growth.

Some of the poorest performers in the Nifty Fifty probably appeared to have (and even did...for a while) attractive growth prospects at the time.
(Not surprisingly, among the bottom twenty were some of the leading tech stocks of that time.)

So, even though the returns for all fifty stocks combined did not turn out to be a disaster in the longer run, consider that:
- Paying such high prices meant an investor back then was in a weaker position to deploy as much capital at the attractive valuations that would later come about.
- Only 15 of the 50 did better than just owning the S&P 500. An investor would have done okay buying all fifty stocks. Yet, if not buying all fifty, what's the chance that an investor (in order to get a good result) would pick at least enough of the high performers and not buy the many underperformers? I'm guessing not all that great.
- The total returns may look okay now, but imagine how underwhelming the returns were for most of these stocks during the initial years after they were purchased. Their per-share intrinsic value needed lots of time to "catch up" to the market price (or maybe a combination of increasing intrinsic value eventually becoming more aligned with a decreasing market price). Probably not unlike what happened with certain overvalued high quality stocks back in the late 1990s. Many stocks from the late 1990s needed a decade or more to bring their value more in line with market prices. As I've said before it certainly wasn't just tech stocks that were overvalued in the late 1990s (actually even earlier than that).
- In 1998, the P/Es of these stocks (and, at that time, the S&P 500 overall) were also quite high even if the market would not hit its peak until the year 2000. So Professor Siegel chose two historically rather pricey points in time.

The top twenty performers in the Nifty Fifty (each started with and had to overcome quite high P/Es) from the market peak in 1972 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). In fact, out of the top 20 performers, fully 18 of them were either small-ticket consumer (11) or healthcare (7) businesses.**

Unfortunately, the window that opened (as a result of the financial crisis) to buy shares of higher quality businesses at very attractive valuations has mostly closed. No matter how good a business might be, what's sensible to buy at a plain discount makes a lot less sense at some materially higher valuation.

More on this in a follow up.

Adam

Long MO, KO, PEP, PG, and JNJ

Related posts:
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

* Forbes magazine added this about the Nifty Fifty: "What held the Nifty Fifty up? The same thing that held up tulip-bulb prices in long-ago Holland—popular delusions and the madness of crowds. The delusion was that these companies were so good it didn't matter what you paid for them; their inexorable growth would bail you out. 
Obviously the problem was not with the companies but with the temporary insanity of institutional money managers—proving again that stupidity well-packaged can sound like wisdom. It was so easy to forget that probably no sizable company could possibly be worth over 50 times normal earnings."
** There have many corporate changes to the Nifty Fifty over the years. So some of these companies are no longer separately traded marketable stocks. They have generally either been acquired by other public companies or are now private. The article summarizes the corporate changes that had occurred up to that point in time. Incidentally, General Electric (GE) and First National City were the two others in the top twenty.
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