The ‘Nifty Fifty’ was the moniker for a set of popular blue-chip US stocks in the 60s and 70s. They were widely regarded as high quality businesses whose growth prospects were so solid that they could be bought and held forever. Well they were until their subsequent crash and underperformance in the late 70s and early 80s. After that, with the benefit of hindsight, the conventional wisdom became that they were an example of a speculative bubble.
I’ve decided to have a look back to see what lessons there are from this experience that can be applied to the current market environment. This has been prompted by some recent commentary. Back in December, Neil Woodford likened the current market environment to the market environment when the Nifty Fifty ‘bubble’ burst, prompting him to warn in no uncertain terms of the impending doom for those holding high quality ‘bond-proxies’. More recently, I’ve read another blog post, which looked at the performance of a few Nifty Fifty constituents since the height of the bubble and found that they didn’t actually underperform over the long term despite the high prices prevailing at the time. Intrigued by this apparent conflict in perspectives, I’ve decided to have a look myself…
Were valuations actually too high in the Nifty Fifty bubble?
In principle, valuations should correctly discount future performance. With the benefit of hindsight and a long term perspective, we can work out on what multiple the Nifty Fifty ‘should’ have been valued at the time, had investors been able to predict the future performance of their holdings. In a well-known article published in 1998, Jeremy Siegel does exactly this.
This article shows that as a group, the annualised return from investing in the Nifty Fifty in 1972 was not far below that of investing in the rest of the S&P 500 over the following 25 years. This suggests that despite being rated on much higher PE multiples than the wider market (on average more than double), the Nifty Fifty were only marginally (relatively) overvalued at the height of the bubble. This implies that they must have been substantially undervalued at just about any other time, particularly so in the subsequent market crashes in the 70s.
Siegel also calculates what the fair value PE multiples should have been, given these subsequent returns. On average, with the benefit of hindsight, the Nifty Fifty should have traded on an average PE multiple of about 40, not far below where it actually did trade at the time. The thing that stands out though, is how broad the spread of ‘fair value’ PE multiples for the individual shares was. At the top end Coca-Cola, Merck and Schering should have all traded on PE multiples around 80. In hindsight, Coca-Cola turned out to be a bargain despite trading on a PE multiple of 46 at the time. On the other hand, a number of shares whose prospects turned out not to be so good should have been valued at PEs of around 10, or even less in some cases.
This shows that the spread of valuations between high quality growth businesses and low quality cyclicals should be very wide – much wider than I think most investors assume. If you are investing in the highest quality large cap growth companies, PE ratios in the 30s and 40s are not actually that high. For smaller cap shares likely to experience sustained and rapid growth it could make sense to pay a lot more. Of course this ignores uncertainty and assumes that you can tell which companies these are in advance – a big ‘if’.
Which stocks were overvalued and which were cheap?
While the Nifty Fifty were only marginally overvalued as a group, this belies a lot of variation underneath. Some were very overvalued and some were very undervalued. This is easy to say with the benefit of hindsight, but was it possible to predict which stocks were which at the time?
The starting valuation within the Nifty Fifty did matter in that those with lower PE multiples did better on average. I think we should be quite cautious in interpreting what this means in general about the power of valuation multiples to predict long term returns. The Nifty Fifty were all much more expensive than the wider market and on average didn’t do much worse over the longer term, even if you invested when the spread of valuations was at its most extreme. What I do get from this is that, within the universe of high quality large caps, valuation multiples do have some predictive power over the long term. You were less likely to do well investing in high quality blue chip companies with PE ratios over 50 in 1972. I expect this must still be true today.
The key factor driving long term returns and so the correct starting valuation is the extent, certainty and consistency of future compound profit growth – what I think of as ‘quality’. Looking back at valuations many years later illustrates how hard this can be to predict and how wildly wrong (or myopic) the market can be. All of the Nifty Fifty were seen as high quality at the time, but only some lived up to their reputation.
There is a fairly striking pattern to which sectors did better and which did worse. Consumer brands and healthcare businesses did very well, while technology businesses did very badly. I think the reason for this must be that investors under appreciated the role that technological change would have in eroding the competitive advantages of certain types of businesses. Polaroid is a useful case study – rated on a PE ratio of 95 in 1972, it was no doubt considered to be a strong growth stock with a solid competitive niche. For a time it was, but it didn’t take long for it to be overtaken by technology. In hindsight it turned out to be grossly overvalued.
There is a lesson for me here. Given technology businesses historically haven’t done so well over the long term, should I be focusing on them as much as I am? Perhaps not. I’m not sure I can apply this lesson too directly, as the nature of technology businesses has changed very substantially since the time of the Nifty Fifty. Information technology in particular has grown massively in significance. Some of these businesses now have characteristics that are likely to endow them with more durable competitive advantages that enable them to successfully adapt to technological change. Online platforms benefit from network effects and enterprise software from higher switching costs. However, the possibility of disruptive technological change creates a lot of uncertainty. This means investors need to be very selective in only backing those technology businesses with the strongest and most durable competitive advantages. They also need to have an appropriately cautious view of long term prospects when thinking about valuation. Consumer brands and healthcare still seem like safer sectors to invest in.
How does the Nifty Fifty bubble compare to the present day?
The difficulty in comparing valuation levels across groups of stocks is that you need to compare like with like for it to be meaningful. It’s not clear what current stocks are equivalent to the Nifty Fifty and suitable for such a comparison. As a rough approximation, I’ve taken the top 30 highest market capitalisation stocks from my watchlist. They are all high quality large caps, though they look a little more growth-oriented than the original Nifty Fifty. Here they are:
|PE ratio||PE ratio|
|Adobe Systems||62||Amadeus IT||26|
|Diageo||28||London Stock Exchange||26|
A superficial look suggests that these valuations are broadly comparable to those of the Nifty Fifty in 1972. The average PE multiple is somewhat higher, but this is skewed by the fast-growing shares of Amazon, Netflix and Salesforce. The Nifty Fifty didn’t include businesses growing quite as fast as these. When you exclude them, the average PE multiple is more or less the same. Consequently, I’d say it is likely that valuations of high quality large caps are about ‘fair’ on average relative to cyclicals at the moment, though within that some shares may be very undervalued and some very overvalued.
A shorter term perspective
We are probably reaching the point at which high valuations imply the long term returns from high quality shares become equivalent to the lower quality cyclicals in the wider market. I don’t think this causes much bother to a buy and hold investor in quality stocks. However, unless you are a true buy and hold investor, you can’t just look at long term valuations. Even if valuations for high quality stocks are still reasonable, previous experience tells us that the market is biased to undervalue quality most of the time and is prone to occasional bouts of irrational short-sighted panic during which the valuation spread collapses. Neil Woodford notes that the spread of valuations is at its highest ever levels and that typically in the past this has preceded a market crash. I’d be inclined to agree with him that the medium term prognosis (5-10 years) for high quality large cap shares is not that great.
While I think this implies a degree of caution is appropriate, valuation in itself is a pretty poor predictor of when a crash will occur. Typically we’d either need overvaluation to reach more extreme levels, like in the dot-com bubble, or for there to be some external catalyst, e.g. from excessive inflation or interest rate rises (as was the case in the late 70s, precipitated by the oil shocks). Excessive caution in advance of a market crash is often more costly than the crash itself.
None of this is cause for me to give up my focus on quality and momentum, but I think it does make sense to pay greater attention to valuations and tilt more to the cheaper shares on my watchlist. Automatically buying small market dips looks like becoming a more and more dangerous strategy.