In the 1960s and early 1970s, there were 50 wildly popular stocks known as the “Nifty Fifty” that seemed invincible. Originally identified by Morgan Guaranty Trust as the fastest growing companies around, the Nifty Fifty were called “one-decision” stocks because you only needed to buy them but never would need to sell them. They were that good.
As investor captivation with the Nifty Fifty grew, so did the prices of its stocks. By 1972, the average Price-Earnings (PE) ratio of the Nifty Fifty was 42, more than double the S&P 500’s. Polaroid traded at a multiple of 95. McDonald’s, Disney, and Baxter had PE’s of 71. Avon’s PE was 61. Those multiples sound crazy now, but then, a lot of people thought these stocks could do no wrong. The commonly accepted wisdom was that these were high quality companies with fast-growing earnings.
It all ended badly for the Nifty Fifty. The market fell apart in 1973-74, the Nifty Fifty’s PE ratios collapsed to 8 or 9, investors realized it was folly to pay any price for growth, and the story was added to the annals of bubbles and manias.
Howard Marks of Oaktree Capital once wrote that when he was working at National City Bank (now Citibank) in 1968, the Nifty Fifty had become what he called “head nodders.” Head nodders, he said, were when “one person says ‘Xerox,’ and everyone else nods and says, ‘great company.’”
That was not a good sign. When too many people like the same thing, prices get pushed too high to make for good investment returns. And when “everyone” thinks something is a great idea, Marks wrote, “it simply cannot be so.” What people often don’t understand, he explained, is that “the very coalescing of popular opinion behind an investment tends to eliminate its profit potential.”
Things don’t always turn out badly when there is a lot of head nodding, but it’s useful to be wary where it lurks. Today, that might be in FAANG or FAAMG stocks (the acronyms for Facebook, Amazon, Apple, Netflix or Microsoft, and Google) -- highly revered companies that may well deliver the tremendous future growth they promise but whose dominance goes largely unquestioned. Or it might be in passive investing through indexes – which has a lot of merits, but where faith in its superiority over active investing is so unquestioned it may be blotting out hard thinking about its risks.
It’s also important to remember that some investments do end up fulfilling their promise of high growth. When Jeremy Siegel took a longer term view of the Nifty Fifty in a 1998 study, he found quite a few Nifty Fifty stocks that grew earnings impressively over the next 30 years -- if you had the patience to stay with them for that long. The difficulty was that the gems were mixed in with a lot of “bad apples.” His conclusions? One was that you often have to pay for growth, which means you shouldn’t automatically shy away from high PE ratios. But at the same time, you shouldn’t pay any price for growth. The stocks in the Nifty Fifty that thrived over the next three decades were generally those that started off with lower PE ratios – and they required patience.
Please note: There will be no 2-Minute Thought on July 13, 2017. We'll return on July 20.