Lessons in Growth Stock Valuation: Spotlight on the Nifty Fifty

When Valuing Companies, Are We Looking Down The Wrong End Of The Telescope?

The Nifty Fifty saga of the early 1970s stands as a testament to the interplay between speculation, optimism, and the valuation of growth stocks. This article revisits the rise and fall of these high-flying growth stocks, explores the rationale behind their astronomical valuations, and extracts valuable insights for contemporary investors. The Nifty Fifty's trajectory, from soaring heights to earth-shattering crashes, unfolds a story that continues to resonate with the fundamental principles of stock valuation.

Amid the exuberance of the early 1970s, a group of growth stocks reached unprecedented heights, only to come crashing down during the harsh 1973–74 bear market. These stocks, often cited as prime examples of speculative excess driven by unwarranted faith in perpetual earnings growth, attracted not just individual investors but also substantial investments from large institutions.

Was the prevailing belief correct that the 1970s bull market grossly overvalued the Nifty Fifty stocks? Or did investors have valid reasons to anticipate that the growth trajectories of these companies would eventually vindicate their lofty prices? At its core, this debate revolves around defining the appropriate premium for well-established, high-growth companies.

The Nifty Fifty comprised premier growth stocks such as Xerox, IBM, Polaroid, and Coca-Cola, which captured the market's imagination in the early 1970s. These stocks exhibited consistent growth records and uninterrupted dividend increases since World War II.

Some of the Nifty Fifty

The Nifty Fifty was a diverse portfolio ranging from drugs, computers, and electronics to food, tobacco, and retailing. Notably absent were cyclical sectors like auto, steel, transportation, and oil. The absence of cyclical industries could have potentially insulated these stocks from some of the economic volatility faced by their peers.

Despite their impressive growth prospects, the Nifty Fifty were known for their elevated P/E ratios. In 1972, their average P/E ratio stood at 41.9, more than twice that of the S&P 500. A mere 1.1% dividend yield contrasted with other large stocks. Some even boasted P/E ratios surpassing 50, with Polaroid soaring to over 90 times earnings. In December 1972, these stocks reached their zenith, marking the height of the Nifty Fifty's mania.

Often referred to as "one-decision stocks," they were considered solid buy-and-hold investments due to their promising prospects. Analysts, believed that these stocks could only ascend, celebrated them as the epitome of reliable investment choices.

During this period, investors demonstrated a surprising willingness to accept high price-to-earnings (P/E) ratios - 50, 80, or even 100 times earnings - for these leading growth companies. Forbes magazine commented that the prevailing mania resembled the Dutch tulip bulb frenzy, fueled by popular delusions and herd mentality. The collective perception was that the companies' quality was so exceptional that price scarcely mattered; their inexorable growth would inevitably save investors from any folly.

In retrospect, this phenomenon's root cause lay not with the companies themselves, but rather the transient irrationality of institutional money managers. The market capitalization of these fifty stocks was large which meant that institutions could take sizeable stakes without moving the market, so these stocks were attractive in that regard. But there was more to it. As Charlie Munger always counsels, we must always consider incentives in understanding behaviour.

When a good fund manager with a solid investment strategy hits a period of under performance relative to his competitors, or to the market as a whole, what do you think happens? Clients of the fund start to withdraw money in search of better performance elsewhere. How short sighted!

This is why it becomes difficult for a fund manager to stick with a unique winning strategy that differs from the crowd. As a professional fund manager, if you do poorly while everyone else is doing well, you run the risk of not only losing your clients but also your job! "

In the words of John Maynard Keynes, “A maverick fund manager who breaks from the crowd will appear eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for one’s reputation to fail conventionally than to succeed unconventionally."

So most fund managers feel that the only way to mitigate that career risk is to invest pretty much the same way that everyone else does. And since it is not possible to beat the market by doing the same as everyone else, they typically under-perform along with everyone else! It is all rather ironic. Sad, but very true. Such behavior serves as a reminder that seemingly rational decisions can be obscured by the veneer of wisdom.

So that explains the herd mentality, which is still prevalent today.

Amid this market frenzy, certain stocks shone brightly, notably consumer brand-name companies like Philip Morris, Gillette, Coca-Cola, and Pepsi-Co. These stocks, alongside drug companies such as Merck, Bristol-Myers, and Pfizer, outperformed the S&P 500. Of course they outperformed, institutional money was inflating their price, often well beyond intrinsic value.

With the benefit of hindsight, the question of whether the Nifty Fifty stocks were overvalued during the 1972 buying spree emerges. While many of these stocks did carry an overvaluation at the peak, a portfolio equally invested in all Nifty Fifty stocks, started at the market's zenith, yielded a 12.5% annual return from 1972 through to August 1998. This suggests that the notion of extreme overvaluation may be overstated, and that a nuanced assessment is necessary.

An intriguing revelation is the concept of warranted price-to-earnings (P/E) ratios. These ratios are reverse engineered, so using shareholder returns in the decades that follow, one is able to work backwards in order to calculate the price that one ought to have been willing to pay for the stock back in 1972. That price, divided by the earnings at the time reveals the warranted price-to-earnings ratio and offers a unique perspective on stock valuation.

Remarkably, using this measure, many Nifty Fifty stocks were worth far more than the market had originally bid them. For instance, Philip Morris should have commanded a P/E ratio of 68.5 times earnings, not the 25.9 that prevailed, underscoring an undervaluation of nearly 3-to-1. Coca-Cola's true value lay above 82 times earnings, while Merck deserved a multiple exceeding 76. These findings challenge traditional notions of valuation and prompt reflection on the dichotomy between market perception and intrinsic worth.

The table below shows the contrast between the price to earnings ratio of stocks that would be deemed relatively ‘cheap’ (lower P/E) and those that would conventionally be deemed ‘overpriced’ (higher P/E).

Multi-Decade Returns from a 1972 start

McDonald’s is an interesting one. It is the most expensive on a conventional P/E basis, but it generated far better shareholder returns than most of the cheaper stocks over multiple decades, so its warranted price-to-earnings ratio was in fact higher than the 85.7x at which it traded in 1972.

So what does this tell us?

What are we able to learn and apply to our own investing?

Do you still want to use P/E as a barometer for value investing?

Many investors today shun Amazon because of its seemingly high P/E, but frame it in the context of a warranted price-to-earnings ratio and it’s highly likely to be another McDonald’s situation.

That having been said, price matters. Even the best stock at the wrong price becomes a bad investment which takes years to work off the excess. So it very much depends on time horizons. The analysis above is all based around long term investing over multiple decades. Those returns could have been further enhanced with better timing on entry of a trade, and to that extent conventional P/E numbers can be useful.

Had you invested in McDonald’s in 1972 at its lofty valuation, it would have taken 10 years before you saw that share price again. A canny investor would have been patient and entered after the draw-down in 1974 instead. Here perhaps conventional P/E ratios may be useful. But for a long term investor, measured in decades, the share price volatility between 1972 and 1984 becomes entirely irrelevant.

McDonald’s share price 1970 - 2020 (zoom 1972-1984)

So our warranted price-to-earnings metric is wholly dependent upon time frame. For short term investors McDonald’s was overpriced in 1972, but for long term investors it was arguably undervalued. This is a concept that most investors have probably never contemplated. The Schrödinger’s cat of valuation - a company can be both cheap and expensive at the same time.

Interestingly, amongst the Nifty Fifty names, it was the consumer brand-name stocks, often overlooked amidst technological marvels, that triumphed. The group of growth stocks that flourished the most catered to the realm of brand-name consumer foods, featuring McDonald's, Pepsi-Co, Coca-Cola, and Philip Morris. In contrast, technology stocks, including IBM and Xerox, faced a less favorable fate. This pattern highlights the unpredictability of market dynamics and the unreliability of industry-wide trends. Tech is often considered the best place for optimal returns because it introduces such radical change to our lives, but looking at this one can’t help reflect on Aesop’s fable of the ‘Hare and Tortoise’. Slow and steady often wins the day.

The enduring lesson from the Nifty Fifty era is the essential trade-off between growth and valuation. The premium associated with growth stocks can transcend conventional metrics, demanding high P/E ratios that are nonetheless justified by sustained growth. This lesson is particularly pertinent in today's market, where investors grapple with the balance between optimistic projections and grounded analysis.

While the Nifty Fifty's crash serves as a warning against excessive speculation and reminds us that even within a constellation of winners, there exist potential losers, underscoring the importance of risk mitigation.

In conclusion, the rise and fall of the Nifty Fifty embody a fascinating case study in growth stock valuation. The euphoria that fueled their ascent collided with the harsh realities of market forces, prompting a reevaluation of their worth. The Nifty Fifty era reminds us that the premium placed on growth can indeed be justified, but that wisdom lies in recognizing the nuanced interplay between valuation, potential, and market dynamics.

I welcome your thoughts, experience and comments in general.