The Not-so Nifty Fifty
Posted on February 12, 2009 by Richard Beddard
Filed Under Investing |
Blowing it away on growth stocks
It’s a tenet of growth investing that the more profitable you expect a company to be in future, the more it’s worth. The more it’s worth, the higher the price investors are prepared to pay for its shares.
The problem is working out how much a company will grow.
In the early 1970’s investors thought they had the answer. It was the Nifty Fifty, or fifty companies that had outstanding records of profitability, had consistently raised dividends since World War 2, and by virtue of their size, dominated the indices.
Institutions bought them with impunity, at prices of fifty, eighty or even 100 times their annual earnings. Then, in the crash of 1973, the Nifty Fifty de-niftified. Polaroid, on a PE ratio of 91 before the crash, fell by 91%. Xerox, on a PE ratio of 49 before the crash, fell 71%.
Since then the memory of the Nifty Fifty has served as a reminder to investors, to watch what they pay for shares, however nifty they are1.
Why dredge up this ancient history? Two reasons:
- Large growth stocks, if you can find them, are in fashion again, although in the current market conditions they’re unlikely to be on PE ratios of 50 and more and
- I’m compiling a ‘Thrifty Thirty’, a list of stocks for Money Observer. Like the Nifty Fifty, they’ll be good profitable companies. Unlike the Nifty Fifty, they’ll be cheap.
So, after the crash of 1973, did the Nifty Fifty recover?
Jeremy Siegel, Professor of Finance at the Wharton School of Pennsylvania studied the returns of the Nifty Fifty in 1998 and concluded that, as a group, they had just about justified the high prices people paid for them in 1970’s. By 1998, their performance had equalled the performance of the S&P500 over the same period, although whether any investor would have held on through nearly twenty years of painful underperformance is another matter.
But his study came with an important caveat. The cheapest 25, the least nifty of the fifty, did twice as well as the niftiest 25.
In 2002 Jeff Fesenmaier and Gary Smith recomputed Siegel’s calculations combining two lists of fifty stocks, either of which could be the true Fifty. They coined their list of 24 ‘unambiguous’ members of the Nifty Fifty that appeared on both lists, the Terrific Twenty-four.
Perhaps they should have called them Terrible Twenty-four. These stocks returned an average of 9.5% a year between 1972 and 2001, which looks innocuous next to the S&P 500’s return of 12%. Because of 29 years of compounding, though, the authors calculated that an investor would have been 50% worse off in the Terrific 24 than the stock market index.
Even Siegel’s conclusion is an indictment of high PE stocks1, I think, confirming, as Fesenmaier and Smith say:
A great company is not necessarily a great stock
Footnotes:
- There was a similar mania in the late 1990’s, although then investors not only paid too much but bought companies of indeterminable quality because they’d no profits or dividends.
- There’s plenty of evidence in Behavioural Investing, academic papers, and, curiously, Jeremy Siegel’s book Stocks for the Long Run confirming that high PE stocks in general do worse than low PE stocks.
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[...] For a discussion of the Nifty 50’s returns, see The Not-so Nifty Fifty. [...]