Baked in the Cake

One-Decision Stocks & The Nifty-Fifty - The Price You Pay Does Matter

Baked in the Cake

The "Nifty-Fifty" was a group of large-cap growth stocks that became the market's darlings in the late 1960s and into the early 1970s. They were great companies that became known as "one-decision" stocks - stocks that you should buy, no matter how expensive, and hold forever. The Nifty-Fifty term was coined because there were about fifty of these companies with very high price-to-earnings (p/e) ratios. Many had a p/e of fifty, or even higher. For example, at year-end 1972 Xerox traded at forty-nine, Avon at sixty-five, and Polaroid at ninety-one times earnings. The bear market of 1973-74 saw these stocks collapse in a manner that was quite similar in speed and size to the collapse that occurred in technology stocks, and large-cap growth stocks in general, in early 2000 when the that bubble burst.

For the ten-year period starting in 1973, large-cap growth stocks performed so poorly, returning just 4.8% per annum, that they underperformed riskless one-month CDs by over 5% per annum. The poor performance was so devastating that even over the entire eighteen-year period 1973-1990 they underperformed one-month CDs, returning 8.3% versus 9.2%. This underperformance led to the disappearance of the one-decision stock, at least for a while.

The bull market in large-cap growth stocks of the 1990s restored their advantage over riskless CDs. For the full twenty-seven year period 1973-1999, they outperformed one-month CDs, 12.6% to 7.7%. And the "New Age" investment mantra that led to the bubble restored the myth of the one-decision stock, as well as the myth that the price you pay does not matter. No price was too great if the company received the praise of star stock analysts such as Merrill Lynch's Henry Blodgett. The following is his statement in a report on Internet Capital Group: "Valuation is often not a helpful tool in determining when to sell hypergrowth stocks" (1). He made this statement on January 10, 2000, shortly before the Internet bubble collapsed.

Helping to restore the myth that the price you pay does not matter came from an unlikely source, finance professor Jeremy Siegel. In his book, Stocks for the Long Run, Siegel demonstrated that the fifty highest-priced stocks on the NYSE had basically matched the performance of the S&P 500 Index. This "demonstrated" that the market was not irrationally pricing those stocks. A study by Jeff Fesenmaier and Gary Smith took a fresh look at the Nifty-Fifty story (2). The results of their work shed new light on how the price you pay matters.

Before reviewing their study an important point needs to be made. The S&P 500 index is a market-cap weighted index, with the biggest stocks having the greatest impact on the returns of the index itself. Of course, the higher a stock's p/e, the greater the market cap and the greater the impact on the index. For example, as of year-end 1999, the largest fifty stocks made up sixty percent of the entire S&P 500 index (3). Thus the large weightings of the Nifty-Fifty would heavily impact the returns of the entire index.

Using data updated through 2001, Fesenmaier and Smith found that an initially equally weighted Nifty-Fifty, using the stocks of the NYSE with the highest p/e ratio, returned 11.64% per annum. A monthly rebalanced and equally-weighted portfolio would have returned 11.85%. The S&P 500 index returned 12.01%.

But the authors went further in their analysis. First, they noted that one of the Nifty-Fifty stocks actually had a lower p/e ratio than the 19.2 p/e ratio of the S&P 500 index itself. They also noted that many did not have what they thought was an especially high p/e ratio relative to the index. Eleven of the fifty had a p/e below thirty, while only sixteen had a p/e above fifty! When they sorted returns by ranking p/e ratio, only three of the sixteen with a p/e above fifty actually beat the index, while eight of the eleven with a p/e below thirty did so. The authors found a strong negative correlation between p/e ratios and returns. Each ten-point increase in the p/e ratio reduced returns by about two percent per annum.

The study also noted that there was no official list of Nifty-Fifty stocks. However, both of the investment firms of Kidder Peabody and Morgan Guaranty each published their own versions of the Nifty-Fifty. Interestingly, only twenty-four of these "one-decision" stocks appeared on both lists. An investor creating an initially equal-weighted (and then frozen) portfolio of these "Terrific Twenty-Four" would have earned a return of just 9.7% per annum. An equal-weighted and monthly-rebalanced portfolio would have returned just 9.6% per annum. The two versions of the "Terrific Twenty-Four" underperformed the S&P 500 by 2.3% and 2.4% per annum, respectively (for twenty-nine years). The impact of compounding the shortfall in returns over the twenty-nine year horizon caused the end value of the "Terrific Twenty-Four" portfolios to be just fifty-four percent (for the frozen portfolio) and fifty-three percent (for the rebalanced portfolio) of an S&P 500 index portfolio, respectively. Note again that these stocks made up a significant percent of the index and thus dragged down the returns of the entire index (if these stocks underperformed the index, the remaining stocks must obviously have outperformed). Therefore, relative to the other stocks in the universe of large-cap stocks that make up the S&P 500 Index, these "Terrific Twenty-Four" did even worse than it appears when simply comparing their returns to the benchmark S&P 500 index.

The conclusion investors should draw is that the price you pay for a company, no matter how great the company may be, does matter. Another conclusion is that investors should never get caught up in a mantra of either "it's different this time" or it's a "New Age." Those who don't know their financial history are doomed to repeat it.

1/14/2003

(1) SmartMoney, June 2001.
(2) Jeff Fesenmaier and Gary Smith, "Nifty-Fifty Re-Revisited," Journal of Investing, Fall 2002.
(3) Bloomberg Personal Finance, April 2000.

Larry Swedroe is the author of What Wall Street Doesn't Want You to Know, The Only Guide To A Winning Investment Strategy You Will Ever Need, and Rational Investing In Irrawtional Times, How to Avoid the Costly Mistakes Even Smart People Make Today. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.