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Monday 27 October 2014

Quality Plays

Rational Exuberance?

One of the odder financial bubbles we saw in the last century was caused by a bout of temporary insanity in the 1970's over a group of the biggest and best American corporations. The so-called Nifty Fifty were, for a while, promoted as the must have, long term buy and hold stocks. And with a certain pleasing inevitability the stocks soared and then, in strict adherence to the law of financial gravity (and very grave it is, too), plummeted. Another mental meme dashed against the rugged rocks of reality.

Only this story isn’t so simple, because the Nifty Fifty weren’t a bunch of story stocks flung high by the whim of investors’ irrational exuberance. They didn’t just disappear having made their owners very rich and their shareholders poorer, and no wiser. The afterlife of the Nifty Fifty tells us an interesting story about the nature and durability of quality in the stockmarket: quality plays, if you understand the rules of the game.

A Swan by Any Other Color

As soon as you go beyond the headline facts, the Nifty Fifty turns out to be one of the least straightforward bubble stories you can find. For a start there's no commonly agreed list of the members of the group: there were several lists from different parties, all overlapping but not the same. Of course, many of the core constituents were the same and, the law of averages being what it is, especially given that we are dealing with a group of very large companies this presumably doesn't matter?

And at one level that’s true, but at another it’s not. The inclusion, or otherwise, of one single stock makes a significant difference to the returns over the next half century. This is a point all too often neglected when analysts and experts discuss portfolio selection and witter on about how many stocks you need to manage risk. But risk has two sides and against the risk of any given portfolio member going bust you have to weigh the risk of any given portfolio member going stratospheric. And, as Jeff Fesenmaier and Gary Smith show, whether you had or did not have WalMart in your Nifty Fifty portfolio would have made a huge difference to your returns:
"Wal-Mart’s 26.96% annualized return over this 29-year period was the third highest in the entire CRSP data base ... Perhaps, buying a high P/E stock is like buying a lottery ticket: the expected return is not good, but there is a chance of a huge payoff."
Black Swans aren't necessarily always bad.


When Jeremy Siegel reviewed the afterlife of the Nifty Fifty (without WalMart), forty years on in The Nifty Fifty Revisited, he came to the interesting conclusion that even if you’d bought them at the peak of their popularity, on extraordinarily high PE ratios, the portfolio would still have made an OK return, against the market, after four decades. Because, in the end, the Nifty Fifty companies were real corporations, doing real things that, by and large, people wanted – and which people still want.

Of course, not everyone agrees. This is an estimate, as many of the Nifty Fifty members have fallen by the wayside over the years. Some have gone bust, others have been taken over and so the issue of what to do with the monies raised when analyzing the long-term performance comes into play. Siegel’s answer is to reinvest them in the S&P 500 – essentially tracking the index.

When Fesenmaier and Smith performed the same analysis they found that the Nifty Fifty underperformed the market: but they reinvested takeover funds in the remaining members of the Nifty Fifty. Everyone has their own opinion on what’s more appropriate, but it’s quite hard to see why reinvesting in the remaining members would be representative of the original intent. But each to their own, I suppose.


So looking for lessons here there are a few striking ones. Firstly, however you measure it and however you select the stocks it’s fairly clear that investing in a diversified portfolio of large corporations with generally reliable earnings has been a relatively safe policy over a long period – forty years is pretty much an investing lifetime for most of us. 

Clearly investing when the stocks in question were at their highest valuations in that period wasn’t optimal, but it’s not turned out to be a disastrous decision: Siegel estimates that the return matched the index, which suggests that as a group they may even have been fairly valued at their peak. Compare this to, say, investing in the highest valued stocks in 1999 or 2000. For every Amazon that’s so far succeeded there’s been a or a that are dead in the water. Given the rate of disruption in the market for technology stocks it’s pure guesswork as to which companies will succeed or fail in the next thirty years.

Paying for Growth

And that’s another interesting thing about the Nifty Fifty. Although, over the decades, many of the stocks turned out to be lacklustre performers a subset of them turned out to be anything but. In fact, retrospective analysis shows that the sky-high ratings paid for some of these stocks back in 1972 actually underestimated their earnings potential. Philip Morris, Coca-Cola, Merck, Gillette, McDonald’s, Disney and PepsiCo (and, of course, if included, WalMart) were the best performers.

In the worst group were Polarioid, IBM, Digital Equipment, Xerox, Texas Instruments and Burroughs. Notice anything interesting about those two lists?

Well, it turned out that companies doing things directly for consumers – fast food, sugary carbonated drinks, cigarettes and drugs – were ultimately the most resilient to disruption over what are now considerable periods of time. The underperformers are a mixed group, but there's a technology bias among many of them – it seems that having to constantly reinvent yourself as the times change isn't easy – in fact it’s a constant battle to stay ahead of an eager crowd of new incumbents. And Microsoft wasn't even a gleam in Mrs. Gates’ eye at this point …

Eat, Drink and Invest

Investors are attracted to technology stocks like moths to a furnace. The lure of exciting new opportunities is hard to resist. But the evidence shows that if you want to invest for the long-term, to lay down investments like fine wines to leave them mature for your retirement, then you’re better off focussing on the basics of what people are likely to want to do tomorrow, and next year, and next decade, and next century. Feed ‘em, drug ‘em, entertain ‘em and if possible addict ‘em. But keep it simple.

Of course, the Nifty Fifty was a child of its time. Had your chosen the group five or ten years later you’d have had a different selection. Times have changed, and we now have indispensable things that we couldn't have imagined half a century ago. The internet has disrupted lots of business models, and will continue to do so. But grocers, and soft drinks, drug companies and fast food outlets are quite hard to reinvent, and if you want to do it better then you’re going to need to be pretty damn clever and have very deep pockets indeed.

The other lesson is obvious. If you’d bought the Nifty Fifty at its peak then you’d have done OK, at least you wouldn't be on the breadline. But if you bought a decade later, when it was on its knees, your retirement would be one long party. Well, as long as all those carbonated drinks, cigarettes and fat saturated fast food hadn't done for you first …


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1 comment:

  1. Ah. I almost forgot about Nifty Fifty. Interesting read. Thanks.