QUALIPORT
Profiting From Expensive Growth Shares

By Maynard Paton (TMFMayn)
May 17, 2005

What did the aftermath of the late-Nineties stock market boom teach you? I bet it was something like 'never overpay for growth shares'.

You see, paying 50, 100 or even 200 times earnings for firms such as ARM (LSE: ARM), Capita (LSE: CPI), Sage (LSE: SGE) and Vodafone (LSE: VOD) was always likely to provide some disappointment -- no matter how fast those companies grew their profits.

But hold on. Jeremy Siegel's superb book, Stocks for the Long Run, reveals how 'expensive' growth shares can in fact pay off over the very long term.

Nifty Fifty

By very long term, we're talking thirty years or so. Siegel's research centres on the early 1970s, when a group of US stocks became known as 'one-decision' stocks -- companies you could buy and hold forever, regardless of price.

Siegel writes: "The episode consisted of a group of high-flying [US] growth stocks that soared in the early 1970s only to come crashing to earth in the vicious 1973-1974 bear market... The "Nifty Fifty" as these stocks were called, was a group of premier growth stocks, such as Xerox (NYSE: XRX), IBM (NYSE: IBM), Polaroid and Coca-Cola (NYSE: KO), that became institutional darlings in the early 1970s.

All these stocks had proven growth records, continual increases in dividends (virtually none had cut its dividend since World War II), and high market capitalisations. This last characteristic enabled institutions to load up on these stocks without significantly influencing the price.

Many investors did not seem to find 40, 50 and even 60 times earnings at all an unreasonable price to pay for the world's pre-eminent growth companies, although many of these stocks sold for barely half the price just a few years earlier..."

At its peak in 1972, the Nifty Fifty had a price to earnings (P/E) ratio of 41.9 -- more than twice the 18.9 offered by the main US index, the S&P 500.

To give a flavour of the optimism, Polaroid boasted a P/E of 95, Disney (NYSE: DIS) and McDonald's (NYSE: MCD) both sported P/Es of 71, Johnson & Johnson (NYSE: JNJ) enjoyed a P/E of 57, Eastman Kodak (NYSE: EK) carried a P/E of 48, Proctor & Gamble (NYSE: PG) had a P/E of 30... You get the picture.

However, by the mid-Seventies, those one-decision stocks had transformed into bad-decision stocks. While the S&P 500 index dropped 48% during the 1973-1974 bear market, the Nifty Fifty lost an average 62%. Within two years, Xerox dropped 71%, Avon Products (NYSE: AVP) fell 86%, and Polaroid -- which had the highest price to earnings (P/E) ratio of the lot -- lost 91%.

Nifty lessons

The Nifty Fifty phenomenon has clear similarities with the market's 1999-2003 boom and bust. But this is what most people don't realise about the Nifty Fifty -- buying them at their 1972 top no longer looks so stupid.

Get this: Siegel calculates that a portfolio of equally weighted Nifty Fifty stocks formed at the market peak in December 1972 would have earned an annual 11.62% return by November 2001, just slightly below the 12.14% return from the S&P 500 index.

Of course, the Nifty Fifty ride from 1972 to 2001 was very long and very rocky. And few investors would have had the emotional stamina to have stayed the course. In fact, anybody who bought into the Nifty Fifty in 1972 first had to wait until 1981 on average before their shares had recovered to their original value. But after another twenty years, the end result was hardly a disaster.

I know this will be hard to believe, but some Nifty Fifty stocks were in fact distinctly undervalued in 1972. For instance, rather than paying 24 times earnings in 1972, investors could have bought Philip Morris (now Altria (NYSE: MO)) for 68 times earnings and still equalled the S&P 500 through to 2001. With Pfizer (NYSE: PFE), shareholders could have paid up to 80 times earnings in 1972 -- rather than 28 -- and still beaten the market.

Furthermore, during 1972, Coke was actually worth up to 56 times earnings (actual 1972 P/E: 46), Gillette (NYSE: G) was worth a P/E of 34 (actual 1972 P/E: 24) while General Electric (NYSE: GE) was worth buying at 43 times earnings (actual 1972 P/E: 23).

Summary

According to Siegel's research (and despite recent history), 'overvalued' growth stocks can do well over the very long term. But picking out the quality winners is difficult. Just thirteen Nifty Fifty stocks beat the S&P 500 between 1972 and 2001, with technology issues in particular (such as IBM, Digital Equipment/Compaq (NYSE: CPQ), Texas Instruments (NYSE: TXN), Xerox and Burroughs/Unisys (NYSE: UIS)) all failing to beat the market. No wonder Siegel counsels: "No one stock or single industry is guaranteed to succeed. Diversification is a key to cutting risks and maintaining returns."

More importantly, however, is how Siegel describes the valuation repercussions of the Nifty Fifty: "As so often happens in financial markets, investors learn their lessons too well. After the wreckage of the Nifty Fifty in 1974, many investors vowed never to pay more than 30 times earnings for any stock, no matter how promising its growth prospects. But Wall Street drew the wrong conclusions from the Nifty Fifty episode of the 1970s. The prevailing cautious attitude towards growth sent the Nifty Fifty stocks to dramatically undervalued levels throughout the 1980s and early 1990s."

We've seen stock market history repeat itself, with optimistic valuations during the Nifty Fifty era and dotcom boom being followed by savage bear markets and dramatic price falls. If Siegel's right, perhaps we'll again witness the market shunning quality growth stocks and leaving them languishing at 'dramatically undervalued levels' in the years ahead.

Going on what happened to the Nifty Fifty, I've no doubt some of the high-flying quality shares of 1999/2000 -- maybe including ARM, Capita, Sage and Vodafone -- will have easily outpaced the FTSE by 2030, even if the shares were bought at the top. As ever, selecting tomorrow's growth winners will be tough. But with the many late-Nineties favourites still up to 90% off their highs, the task should now be a little easier.

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