THREAD---From BARRON'S on the nifty fifty and valuations---
arch 15, 1999
Today's Nifty Fifty
Memories of the 1970s raise a question: Are these giants worth
it?
By Andrew Bary
What price greatness? That's one of the key questions facing investors
these days, given the phenomenal ascent of stock-market leaders like
Microsoft, Cisco Systems, Dell Computer, Pfizer and Wal-Mart in the past
few years. There's no precedent for the high valuations of these giants and of
the overall market, which, using the S&P 500 as a benchmark, now trades at
a record 28 times trailing 12-month earnings and at 26 times projected 1999
profits.
Not since the fabled Nifty Fifty market of the early 1970s has a favored
group of stocks came close to reaching the heights now occupied by the
current leaders. Those were the days when Eastman Kodak, Polaroid, Avon
Products, Disney and Coca-Cola traded at price/earnings multiples as high as
95.
The subsequent plunge of the
original Nifty Fifty, long
viewed as just retribution for
absurdly valued stocks, has
been subject to a revisionist
interpretation by Jeremy
Siegel, a professor of finance
at the University of
Pennsylvania.
In his book Stocks for the
Long Run, Siegel laid out a
bullish argument for equity
investing and calculated that
an investor paying top dollar for the Nifty Fifty in late 1972 would have
earned nearly the same returns over the next 25 years as someone holding the
S&P 500 (Barron's, March 30, 1998).
Siegel has recalculated the returns through the end of last August and come up
with similar results. Over the extended span, the original Nifty Fifty produced
a 12.5% annualized return, slightly behind the 12.7% for the S&P. The table
on this page shows the returns of the individual Nifty Fifty stocks. The returns
on them and on the S&P would be higher if calculated until now, and the
spread likely would be narrower, given the strong showing of the Nifty stocks
since the market's August lows, Siegel surmises.
Tables: Were They Worth It? | The New Nifties
"Good growth stocks are expensive, but they can be worth the price," he
adds. His conclusions have buttressed the arguments of growth-stock
enthusiasts, who maintain there is no better place to invest over the long run.
Yet the valuations of many of the original Nifty Fifty pale besides those of the
market's current elite. Barron's compiled a new Nifty Fifty by selecting 50
growth stocks from among the 80 largest companies in the S&P 500. This
group trades at an average of 50 times 1998 earnings, above the average of
42 for the original Nifty Fifty. The P/E multiples of the current crew admittedly
would be lower if calculated using current-year estimates. But trailing earnings
were used to facilitate a comparison with 1972, when forward profit estimates
weren't readily available.
What does Siegel think of the new Nifty Fifty? He hedges a bit. "The notion
that good growth companies can't be worth more than 50 times earnings has
been disproved by the facts," Siegel says. This is evident in the table, which
shows what Siegel calls the "warranted" P/E of the original Nifty Fifty, using a
stock price then that would result in a return equal to the S&P 500 over the
ensuing 25 1/2 years. Coke, for instance, traded for 46 times earnings in late
1972, but was actually worth 82.3 times profits, given its market-beating
performance since then. Put another way, Coke was worth almost double its
price at the time.
That said, a glance at the table shows that some of the best performance has
been generated by lower-multiple (at least in relative terms) stocks like Philip
Morris, Pfizer and Gillette, while nearly all the super-high P/E stocks lagged
behind, including Polaroid, Avon and International Flavor & Fragrances.
Siegel declares that only a handful of the "best growth stocks in the past" have
been worth more than 70 times earnings. He therefore wonders how America
Online, for instance, will ever justify its P/E of 353 over the long run,
especially in view of its already huge market value of $100 billion. The
professor cites Microsoft as one stock that could well live up to its lofty P/E
of 70, yet it's worth remembering that IBM was once thought to be invincible.
Siegel's research shows that technology companies have a tough time
maintaining an edge over the long run. A glance at the winners from
yesteryear's Nifty Fifty shows several large drug companies, including Pfizer
and Merck, as well as consumer multinationals like Coca-Cola and Gillette.
The leading tech companies from 1972 have badly trailed the S&P 500 since
then, including IBM. Of course, the fans of today's premier technology
companies say that the current leaders are far superior to the tech class of
1972.
Another big difference between then and now is size. The new Nifty Fifty
have taken over the S&P 500. Back in 1972, the Nifties represented an
important group of stocks, but the market was still dominated by non-Nifty
industrial outfits like General Motors and Ford, utilities such as AT&T and the
major oils.
When Barron's formed a new Nifty index from the largest companies in the
S&P, nearly all the top 20 fit the bill -- the exceptions were Exxon and
BankAmerica. We defined Nifty companies as those with relatively high P/Es
and projected profit growth. We didn't have to go below the 80th company in
the index, Walgreen, to find 50 Nifty names. Reflecting the Nifty character of
the current market, the P/E gap between the largest companies in the key
index and those in the middle or bottom has rarely been so wide.
The matter of size is important. It's one thing for small companies to grow
rapidly for extended periods. It's another for behemoths. "Very few large
companies are worth 75-100 times earnings, no matter how you justify it,"
argues Ross Margolies, manager of the Salomon Brothers Capital fund. "At a
certain point," he adds, "it becomes mathematically impossible" for big
companies to grow rapidly enough to justify their multiples.
Michael Goldstein, the equity strategist at Sanford Bernstein, observes that
the entire tech sector now is discounting 14%-16% profit growth annually
over the next 10 years, an expectation he deems "optimistic" in light of market
history. An annual growth rate of 14% implies a near-quadrupling of tech
profits during the next decade. The Internet stocks, he adds, now discount
29% annual profit growth over a 10-year span, a phenomenal 13-fold rise.
The counterargument comes from Thomas McManus, strategist at
NationsBanc Montgomery. "It's a mistake to say that these Nifty companies
are so muscle-bound that they can't continue to grow in a mature U.S.
economy," McManus says. "They're global leaders." Siegel makes the same
argument, noting that the Nifties of yesteryear were largely limited to the
domestic market and Western Europe.
McManus adds that many of the Nifties also have plenty of growth potential
domestically because their revenues aren't a significant part of an $8 trillion
economy. Microsoft, for example, had under $17 billion in sales in 1998,
while Cisco had $10 billion. "The overlap between the S&P 500 companies
and the U.S. economy is less than many people realize," he says.
The other argument in favor of the Nifties is that their multiples are justified
because they're producing strong profit growth when the rest of the S&P 500
isn't. The members of the Barron's Nifty list enjoyed profit growth last year of
20%, on average, excluding MCI WorldCom and AOL, which had huge
increases off depressed bases. By contrast, operating earnings for the entire
S&P 500 were up about 3% in 1998. This means the non-Nifty part of the
S&P had falling profits. The outlook for 1999 is much the same.
Tom Galvin, the strategist at Donaldson Lufkin & Jenrette, notes that the
market has been very efficient at rewarding companies with good earnings
gains and penalizing those that fall short. He believes the market's largest
stocks suffer from a form of "reverse discrimination" on Wall Street. "Most
analysts don't want to cover them because they feel they can't add value," he
says. The same argument is used by portfolio managers for not owning the
giants. Even with the rising popularity of index funds and the push by active
managers to align their portfolios more closely with the S&P 500, the big
stocks still aren't heavily represented in mutual-find portfolios.
Most observers, Galvin says, attribute the continued woes of small stocks to a
simple liquidity preference among big institutional investors. But he believes
another key factor is at work: "It isn't necessary to go to small companies to
get high growth." Investors, he says, can find high-growth companies right at
the top of the S&P 500. Take Microsoft. Its profits grew an astounding 74%
in the December quarter, after expanding 45% in the year-earlier period.
Galvin thinks most institutional managers hope the Nifties get their
comeuppance: "They hate the Nifties. They think it's the eve of 1973 again."
When will the Nifty market end? McManus concedes that the expansion in
Nifty P/Es has reached almost "exponential" proportions -- a trend that
obviously can't last forever. But he says the Nifty phenomenon can go on
longer than "most of us can afford to ignore."
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