May 19,
1998/FOOLWIRE/ -- Stocks for the Long Run by esteemed Wharton professor
Jeremy J. Siegel has been a popular book around Fool HQ for a couple years.
It's been so popular, in fact, that we've somehow "lost" the 1994 edition.
Luckily, the 1998-copyrighted second edition has just been released.
Subtitled "The Definitive Guide to Financial Market Returns and Long-Term
Investment Strategies," the book benefits from Siegel's years of teaching at
one of the country's most respected colleges of finance and it is an
excellent introduction to common stock investing for beginners with an
acquaintance with statistics or for the more advanced who are looking for a
good resource on stocks.
Perhaps the most interesting part of the book is chapter 7, "The Nifty Fifty
Revisited." The Nifty Fifty was a group of stocks that people believed could
be bought at any price because their earnings growth was so dependable and
robust that the valuations at which they were purchased mattered little for
those looking to hold for the long term. The experience with the Nifty 50
"one-decision" stocks over the past 25 years has been cited whenever someone
wants to make the point that you can overpay for "great companies." Sure
enough, that is true, but sometimes you can't pay enough for the truly great
companies.
Siegel's evaluation of the data starts out with the rhetorical question,
"Did the Nifty Fifty stocks become overvalued during the buying spree of
1972?" "Of course they did!" many will scream. It's become the accepted
wisdom among the perma-bear crowd and the "value" cranks that the Nifty
Fifty episode was the height of insanity, a modern-day tulip mania. Siegel
answers the question in the affirmative, but says that these stocks were
overvalued "...by a very small margin." As we have repeated God knows how
many times now, a truly great company priced at its intrinsic value will
always look horribly overvalued in relation to its current earnings. In
other words, you can pay outrageous multiples to current sales and earnings
and still outperform or perform in-line with the market if you had perfect
foresight on the company's future returns on capital and capital allocation
policies. No one has perfect foresight, though. In lieu of that, you have to
find companies with excellent economics.
A company priced at its intrinsic value is priced such that its total return
over a given time period in the future will be equal to the return of the
market in general. This is an assumption I make in my somewhat controversial
columns on Amazon.com (Nasdaq: AMZN). I argue that its current price/sales
and price/earnings ratios are irrelevant, because the market is not
discounting those numbers -- it is discounting the future financials. Of
course, the market is only guessing at how the company will do, while I make
no claim whatsoever as to whether the company is priced above, at, or below
its intrinsic value. According to the data Siegel presents, the market can
overprice favorite stocks, but it can also severely underprice other
investor favorites. Intrinsic value is not easily calculated.
Between December 1972 and June 1997, the Nifty Fifty generated a compound
annual return (CAR) of 12.4%, without re-balancing the portfolio.
Rebalancing monthly, the portfolio of Nifty Fifty stocks returned 12.7% per
year, compounded, over this time period. How did the S&P 500 do? 12.9%
compounded annually. (All of these are total returns, which include
dividends reinvested.)
Some lessons to draw from the group should be remembered, though. 1) You
can't pay any price for any stock that the consensus deems to be "great."
Phil Fisher raves about Texas Instruments (NYSE: TXN) in Common Stocks,
Uncommon Profits. In the post-war world, this was a killer company. However,
its returns to shareholders before the peak of the Nifty Fifty era were not
matched by its post-Nifty Fifty peak performance. During the period of the
study, Texas Instruments generate a CAR of 9% per year. From 1972 to 1995,
the company's CAGR in per-share earnings was 12.7%. Since its EPS outgrew
the return on the stock, the data indicate that the company ended the
25-year period at a P/E lower than the 39.5 time earnings at which it
started the period.
To get to intrinsic value of the company at the beginning of the period,
Siegel presented a "warranted P/E ratio" for the companies in the Nifty
Fifty. At this price, each would have performed in-line with the S&P 500
over the ensuing 25 years. Texas Instruments should have been priced at 19.4
times earnings in January 1972 to match the market over that period.
Calculators, aerospace, and DRAM chips made the early owners of TI quite
rich, but the latecomers overpaid.
What about some of the companies that would be included in the Nifty Fifty
today? Coca-Cola (NYSE: KO), which has generated a compounded annual return
of about 16.5% since going public in 1919, generated a CAR of 17.2% during
the period encompassed by Siegel's study -- nearly in-line with its 78-year
historical performance. Did Coke need to be priced at a level only a "value
investor" could appreciate? Hardly. At a P/E of 46.4, some insight into the
excellent economics of Coke would have steeled the nerve of a potential
buyer. According to Siegel's data, the company would have to be priced at a
ridiculous-looking 92.2 times earnings in 1972 to have performed in-line
with the S&P 500 over the ensuing 25 years.
It does help that Coke's earnings power was expanded greatly by the
introduction of the blockbuster Diet Coke during the time period covered by
the study, though one could argue that the performance of that drink could
attributed to the inherent power of the Coke brand. It also helps that Coke
is valued at nearly the same level now as the level at which it was priced
in 1972. If Coke were priced at 10 times earnings and inflation were now
running at 9% annually, the CAR of the stock would be much, much lower.
Priced currently near 50 times earnings, the company's CAR of 17.2% has
actually run ahead of Coke's 13.5% annual EPS growth rate (though the
composition of earnings per share may be different in the two periods).
What may be surprising to some is that Coke is not it when it comes to being
the winning stock in the Nifty Fifty. Cigarette and foods company Philip
Morris (NYSE: MO) won the contest with a 19.9% CAR from January 1972 to June
1997. During that period, the company grew EPS at a compounded annual rate
of an amazing 17.9%. Starting out with a P/E of 24, the company could have
been priced at 78 times EPS to have performed in-line with the S&P 500 over
the following 25 years.
Philip Morris could have been priced at 50 times earnings and easily refuted
the dour warning of Forbes magazine in 1977: "It was so easy to forget that
probably no sizable company could possibly be worth over 50 times normal
earnings. As the late Burton Crane once observed about Xerox, its multiple
discounted not only the future but also the hereafter." Oh, what a joyous
place America was in the post-Watergate Carter era. Forbes hedges its bets a
bit, saying, "probably no sizeable company." In the period covered by
Siegel, not only Philip Morris outperformed, but so did Gillette (NYSE: G),
Pfizer (NYSE: PFE), PepsiCo (NYSE: PEP), Bristol-Myers Squibb (NYSE: BMY),
Merck (NYSE: MRK), General Electric (NYSE: GE), and Procter & Gamble (NYSE:
PG). Of these stocks, an investor could have paid anywhere up to 50 times
earnings and still outperformed the market.
Now, this isn't advice to pay anything for any stock. Let me make this clear
right now. Most companies possess crappy economics that cannot outperform
the S&P's collection of the best and brightest 500 large companies that are
traded in the U.S. Most companies are not worth owning at anything but the
cheapest price, while some companies are merely attractive at current market
multiples. Even the best companies bought at very high current valuations
can turn in discouraging performance over a five or even 20-year span. The
current state of the market bails us out on looking at compounded annual
returns of these companies because valuations are high today. However, we
are measuring peak-to-peak (if this is a peak, which I have no idea about)
performance, not trough-to-peak as some do to boost representations of
returns. At both ends of the Siegel study, stocks were "expensive."
It's interesting to note that most of the Nifty Fifty underperformed the
market over the ensuing 25 years. That's pretty much always the case. Over
time, the companies with good economics spank those with mediocre to poor
economics. As with any portfolio of stocks, there will be winners and
losers. The trick to outperforming the market is to identify those companies
with poor economics and not pay a high price for them. Identifying those
companies with excellent economics and at least a competent to good to
brilliant management team is more than half the battle in beating the S&P
500. "Value" is a component of growth, not just price. You HAVE to be right
about quality, but sometimes it's hard to pay too much for excellent
quality.
-- by Dale Wettlaufer |
