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Are some businesses so great that their valuation is irrelevant?

04/10/2016

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Can an expensive business really ‘grow into its valuation’? Here on The Value Perspective, we have started to notice certain investors asserting this as a way of justifying buying into highly-valued companies in, for example, the tobacco, beverages and consumer staples sectors. If it sounds familiar, it may be because from time to time a similar argument is made about the so-called ‘Nifty Fifty’ – and we have never found it convincing.

The ‘Nifty Fifty’ was the name given in the 1960s and 1970s to a group of large New York Stock Exchange-listed companies – the likes of Avon, Coca Cola, IBM, Polaroid and Walt Disney. Seen as the embodiment of the American Dream, they were often painted as ‘one-decision’ stocks – the sort you could buy and then never need to sell because they would keep on growing. By the early 1970s, they had duly grown very expensive.

The severe 1973/74 bear market revealed the Nifty Fifty to be not so nifty, however – and indeed, by most counts, it never actually numbered 50 constituents. Despite those two small issues, it has over the last four decades continued to be referenced by investors, who – as we are seeing now – want to believe some businesses are simply so great it does not matter what you have to pay to own them.

Here on The Value Perspective, we are by no means alone in viewing the Nifty Fifty as a salutary warning against paying too high a price for stocks. Nevertheless, some prominent financial thinkers have been prepared to argue differently – including US academic Jeremy Siegel, the author of Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies.

In a 1998 article, Valuing growth stocks: Revisiting The Nifty Fifty, Spiegel acknowledged the businesses were often held up as “examples of speculation based on unwarranted optimism about the ability of growth stocks to continue to generate rapid and sustained earnings growth”. But he went on to contend that, if you had held onto your Nifty 50 stocks for a couple of decades after they crashed, you would have caught up with the market.

As such, Spiegel argued, the elevated prices some investors had been prepared to pay at the start of the 1970s must have been the right price. Other academics have since repeated this defence of the Nifty 50, cherry-picking certain businesses that have gone on to thrive. This has, however, forced some academics to question the Nifty 50 supporters’ methods of calculation – not least because there is no official definition of the grouping.

This was the approach taken, for example, by Jeff Fesenmaier and Gary Smith in their pointedly-titled The Nifty-Fifty Re-Revisited. Here on The Value Perspective, however, we would argue that – regardless of how you define the group and your subsequent method of calculation – you do need to be very careful about the conclusions you draw and how you frame them.

The figures Spiegel used 20-odd years ago have since been updated to show that, four decades on and despite a couple of further setbacks along the way, the Nifty 50 has again broadly caught up with the market. As such, the logic supposedly runs, if you had managed to hold onto your portfolio of stocks for 40 years or so, you would have broken even on your investment.

Win the lottery

To such an argument, we would offer a couple of observations, the first of which is, if you were going to try a similar trick with a view to retiring at the age of 65, you would need to be 25 now – and certainly there are not many investors making the ‘a great stock will grow into its valuation’ case who can say that. For another thing, you really need to win the lottery with your portfolio because the vast majority of Nifty Fifty returns came from one company.

Having been founded in 1962, Walmart was still a relatively young business when it was considered part of the Nifty Fifty but, according to one study of the group by US securities firm Kidder, Peabody & Co, it went on to compound at a rate of 30% a year to grow by 15,854% – more than 10 times the next best showing, recorded by Hewlett-Packard. Over the same time, around four-fifths of the Nifty Fifty underperformed the market.

And yet the most striking aspect of any debate about the long-term validity (or otherwise) of the Nifty Fifty grouping before the crash of 1973/74 is that, if you had simply waited until 18 months after their peak, you would have been able to buy the exact same stocks on valuation, as opposed to growth, multiples. In that period, for example, Xerox fell 71%, Disney 82%, Avon 86% and Polaroid 91%.

Remember – these were all ‘one decision’ businesses that people had been talking up in the early 1970s for their stability, their quality and the fact you could buy in and never need to sell since they would just keep on growing. What they were certainly not billed as were companies that could see three-quarters or more of their value erased in a year or so’s time but, never fear, you will get your money back in a decade or two.

To hammer the point home, the reason investors made their money back all those years later was that, having plummeted 75% or more, these business had become value stocks – and value did well. And if you had been guided by valuation, rather than the more tenuous prospect of eternal growth, and bought the cheapest businesses in the market, you would have done significantly better than buying the Nifty 50.

But not everyone is willing or able to learn the lessons of history – a notable example being the leading US financial magazine Forbes, which in September 1986 published its own updated ‘Nifty Fifty’ growth list. To be fair, this came spookily close to mirroring the group of companies that inspired it – pretty much being wiped out in the 1987 crash just over a year later.

Coming as they tend to do after significant periods of equity market success, subsequent exercises in updating the Nifty Fifty have hardly fared better – brought down by the bursting of the tech bubble, say, or the 2008 financial crisis. And what about now – as some investors effectively ‘re-re-re-re-revisit’ the argument some stocks are just so great their valuation becomes irrelevant? As we suggested recently in Crash course, the shortness of market memories means the same lessons have to be learned over and over again.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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