The lessons from the Nifty Fifty. Are we repeating the same mistakes of the past?

Finance & Fury Podcast

Welcome to Finance and Fury. Today’s episode is lessons from the nifty fifties – bit of a history lesson as well as looking back to lessons that can be learnt from this, to help not make mistakes of the past.

This is a particular bubble and market correct that most people wouldn’t be familiar with – especially when compared to the 1929, 1989, or 2008 crashes which were more world wide or a complete systematic risk

This mini-bubble occurred in the US back in the 1970s –

1. the term Nifty Fifty is an informal designation that was given for fifty popular large-cap stocks on the NYSE
   1. These shares were particularly popular in purchases between the 1960s and early 1970s
2. This basket of shares was widely regarded as solid buy and hold growth stocks – they were essentially Blue-chip stocks - your large companies that were considered lower risk
   1. The group included names like Revlon, Procter & Gamble, Philip Morris, Pepsi, Pfizer, Merck & Co, Eli Lilly, Coca-Cola, IBM, Gillette, Wal-Mart, Disney, Eastman-Kodak, Xerox and Polaroid – a lot of these are still household-names today, although some, like Eastman-Kodak are no more
   2. Some academics credit these fifty shares as being the primary reason the US had a bull market of the between the 60s and early 1970s –
      1. But this then turned into a subsequent crash and underperformance of the market through the rest of the 70s and into the early 1980s
   3. It is interesting – because when you look at a market/index – depending on the weighted allocation of a basket of shares – the performance of the top 50 large shares on an index that has thousands of shares listed on it is more important than all of the other shares combined
   4. As an example – think about the ASX – the top 50 companies make up between 70- 75% of the market cap of the index
      1. If these shares have a negative 10% return, but the remaining 2,700 shares have a positive 10% return, results in a negative 5% return to the index – due the weighting of the index – where what is most important is that the companies that make up the most of it perform well
   5. Where this gets even more concentrated is on an index like the NASDAQ –55% of the index weighting is held in 10 companies – Apple, Microsoft, Amazon, Tesla, FB, Alphabet A & C, Nvidia, paypal and comcast
      1. NASDAQ has done pretty well over the past 10 years – thanks to the rise of companies like Apple, amazon and tesla –
   6. Similar dynamics were playing out back in the 60s – thanks to a handful of shares -the NYSE rose significantly
      1. We will go through what happened in detail – but it is an example of what may occur following a period during which many new investors start joining the markets, which are then influenced by a positive market sentiment, providing a feedback from further positive returns, ignoring fundamental market valuation metrics in the short term – then a trigger catalysis occurs and the house of cards crashes down

Starting at the beginning - the most common characteristic by the companies in the nifty fifty could be described as investor optimism -

Looking back in time on the Go-Go Years

1. The 1960s were buoyant years for the US economy and stock market. From the mid-60s the term ‘go-go’ was used to describe an aggressive way of operating in the stock market, which involved trading for quick profits.
2. Many of these companies were either providing solid earnings growth, or there was the expectations of solid earnings growth in the future
3. This attracted a lot of attention and new Investors came to the market
   1. This is actually a key feature of the 1960s that could be easily overlooked – and that is that there was a massive increase in the number of investors in the US stock market
      4. Seven times as many Americans held shares by the end of the 1960s when compared to 20-30 years earlier - In the summer of 1970, the US Stock Exchange unveiled a survey showing the country had over 30 million shareholders – population of 200m – so 15% of the population – but it was previously only 4.3m when the population was closer to 150m – which is 3% of the population
   2. Chicken or the egg situation – was the rising market the reason for new investors, or were new investors the reasons markets were rising
      1. Probably a bit of both – whilst throwing in there the population growth and increased in accessibility to the market
         1. As a population grows – there are more people who can invest – as the access to invest increases, the number of people invested will also rise – but what incentivises these people to invest is to generate wealth – so a rising market can expediate these factors
      2. One of the major factors in this which shouldn’t be overlooked was the increase in access to the market that occurred in the 1960s due to innovation
         1. The decade saw the rise of the professional fund manager - It was the period in which managed funds started to be established and saw large fund inflows – by the mid-60s managed funds accounted for around a quarter of all transactions in the market and this only rose over the next 10 years
      3. Back in the 1960s – the influx of new investors had only ever experienced a prolonged bull market, another factor sustaining the bubble in the Nifty Fifty.
   3. Either way – what materialised by the 1970s is that each of the large cap shares started to carry extraordinarily high price–earnings ratios – a PE of 50x was relatively normal - far above the long-term market average
      1. The group included names like Revlon, Procter & Gamble, Philip Morris, Pepsi, Pfizer, Merck & Co, Eli Lilly, Coca-Cola, IBM, Gillette, Wal-Mart, Disney, Eastman-Kodak, Xerox and Polaroid – a lot of these are still household-names today, although some, like Eastman-Kodak are no more
      2. What was said by many investors back in the 1960s is that these shares should be bought and never sold - became the majority holdings in many institutional investor’s portfolio (managed funds) as well as in personal portfolios
   4. But then the issues started to emerge – the major problem was the Price/Earnings ratios being sustainable in the long term
      1. The price/earnings (PE) ratio is a valuation measure which compares the market price of a company to its earnings per share – you take the price and divide by the EPS
      2. The PEs of some of the Nifty Fifty moved into stratospheric territory as the 1960s progressed. By the early 1970s, the highest rated companies, darlings of the market, were trading on stunning valuations: Johnson & Johnson (57.1x), McDonald’s Corp (71.0x), Disney (71.2x), Baxter Labs (71.4x), International Flavours & Fragrances (69.1x), Avon Products (61.2x), Polaroid Corp (94.8x) and MGIC Investment Corp (68.5x).
      3. We might compare these valuations with those of the top holdings in the NASDAQ – Amazon is about 76x, Tesla is at about 1,000x, NVIDIA is about 76x, with the rest of the between 30-40 PE
      4. Some of these valuations are around the same – but some like Tesla exceed it to the extreme
   5. Enter the bear market of 1970s
      1. The long bear market of the 1970s which started to emerge – triggered by the 1973–74 stock market crash– this was a rather long one as it lasted until 1982 before markets started to recover –
      2. The issue with a very large segment of the market cap – concentrated in a few companies with very high PEs makes the market more fragile – If a market correction occurs, the companies that are overvalued can be sold off harder and faster – the crash in 1973 caused valuations of the nifty fifty to fall to low levels along with the rest of the market, with most of these stocks under-performing the broader market averages
         1. Similar to the rise of the market – if the largest segment of the market is overvalued and crashes – then this can drag down the whole index
         2. These shares didn’t all fall in tandem though - they were dropping one by one - some of the share price declines to 1974 lows were huge: Xerox (-71%), Avon (-86%) and Polaroid (-91%). The vulnerability of highly-rated companies to rising risk aversion was revealed – due to them starting on massive valuations in the first place
      3. There is one notable exception to this group – and that was Wal-Mart – which is the best performing stock on the list – has provided a compounded annualized return over a 29-year period of 29.65%.

But what happened to create such a drop in this segment of the market? It had been a long party for investors which had to come to an end – but there was no one cause – there was political instability with Nixon and Watergate, profit taking for investors, rising inflation

1. I think one of the biggest contributors were rising interest rates, the end of the Bretton Woods monetary system and valuing growth – I’ve talked about the importance of interest rates and the yields on 10 year government bonds in previous episodes – this actually relates to one of the leading contributors for the market correction
   1. interest rates and discounting – the yields on the risk-free rate on a 10-year treasury – Say you have a company earning $100 today, but is forecasted to earn $200 in 10 years’ time
   2. When the risk-free rate is low – the discounting to present value for cashflows isn’t as severe – so why not hold out for that higher earnings in the future – but when the risk-free rate is higher, and discounting is higher as well – you start to care more about the cashflows today – in present value
   3. Take this example further – if the RF rate is 1% - and you have one company earning $100 today, but isn’t going to grow, versus another company earning $2, but is expected to grow at an earnings rate of 50% p.a. (which is huge for constant growth) – in 15 years’ time, which would have had the best free cashflow in PV? The company earning $2 today is worth around $2,303 of PV in cashflow, the company earning $100 is worth $1,386 – so the growth company is worth much more – but if the RF rate is 10.5% - they have the same PV in cashflow over a 15-year period
2. Looking back on the risk-free rates – in the 1963 – 4% then started to rise, 1967 – went to 5.1%, 1969 – 6.7%, 1970 – 7.4%, 1975 – 8%, 1980 – 11.4%
   1. A lot of this had to do with the change in monetary system – and rampart inflation, so rates were pushed up to help combat this
   2. But had the effect of the valuation of companies starting to drop due to the discounting methods – so if you are a predicted growth company with a massive PE today – it isn’t good news for you
3. Hindsight is 20/20 – and looking back, common sense suggests that many of these Nifty Fifty companies were in a classic investment bubble due to the investment flows and huge PEs - driven by what drives most bubbles - strong economic growth forecasts and plentiful liquidity (or money flowing into these companies) – pushes up valuations to unsustainable levels over the short-term
   1. This example does help to point out unrealistic investor expectations – and that nobody knows the future – what is the best company today may fall over tomorrow – people in the 50s and 60s probably though that polaroid was going to be the next big thing for decades to come – and it was – which is why it made the list – today it is a defunct company that filed for bankruptcy over 15 years ago and has been passed around in the private world, constantly losing valuation along the way
   2. Or even Xerox – Didn’t go bankrupt but has the same price today as it did in 1980.

What to do with this information – these examples do help to highlight the dangers of a long, late-cycle bubble for equity investors – as there are some similarities to markets today –

1. New investors – similar to the 1960s increasing the access to markets - the increase of Index funds and ETF access over the past decade has had a similar effect, but magnified – this has been magnified by the internet, the increase in technology allowing increased access to equities
   1. Back in 1970 – 15% of the population owned shares in the US – today it is 55%
   2. The average wealth has also increased – so the amount of money through all of these compounding factors – i.e. more people investing with greater sums of money has had a positive inflationary pressure on markets
2. New investors have only known positive markets – increases the level of exuberance in markets
   1. Looking at listings – so many new ETFs coming to the market – we have only really known a bull market since 2012 – have been some corrections – but the markets ended up with positive years
   2. People jump into them without even thinking or without any knowledge of historical performance of the underlying companies
3. Market valuations – these are very high at the moment and concentrated in many well know large cap shares which are considered house hold names, or long term buy and holds – but there are some risks to this
   1. Interest rates - Current interest rates - estimated to be around 0.9% for the risk-free rate
      2. In 2018 – was about 2.9%, in 2001 – was 5% - has the capacity to increase valuations for companies not currently earning anything but may someday through the roof – but still – the PEs in some companies listed on the market are 0 or negative
      3. If RF rates do go back up - Markets will start to care more about current income/cashflow in present value cashflow when the risk-free rates rise – covered this last week on the case for value shares
   2. Technology and adaption – many competitors may come out and what is natural in business cycles – when companies get too big, it becomes hard for them to adapt
   3. Even high-quality businesses can be poor investments if they are bought at extended valuations – like with a house – you can have a very nice house – but if you pay twice the market valuation – it may take you decades to get your money back if you were to sell
      1. Buying a great company at a fair price is better than a great company at a massive price
   4. In financial markets – there should always be a focus on capital preservation - consider the potential downside of any investment
   5. In my view – one of the best ways to do this in the current market is to not hold purely large cap companies – nature of markets over time to replace market leaders –
   6. Still focus on investing for the long term – whilst many of the nifty fifty crashed in the 70s due to their extreme levels of overvaluation - if you had continued to hold stocks such as Walmart, Coca-Cola or McDonald’s, from the 1970s peak until the present day - you would have still made decent returns
4. But as always – important to diversify property – and not pay more than a company is worth – and take advantage of downturns

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