<THE RULE MAKER PORTFOLIO>
Nifty Rule Maker?
ALEXANDRIA, VA (August 30, 1999) -- First things first, in the next five trading days, we will purchase ~$500 worth of shares in Cisco Systems (Nasdaq: CSCO). The decision to add to Cisco was detailed in the following articles:
- Rob Landley on Cream Skimming -- 8/25/99
- Phil Weiss says, "Let's Buy More Cisco" -- 8/26/99
- Tom Gardner sings the praises of Cisco and Microsoft -- 8/27/99
- Original Cisco Buy Report -- 6/22/98
Moving on, today's topic is one that bristles the feathers of many a Rule Maker naysayer -- valuation.
Corporate America's earnings have become increasingly prized among investors. Back in 1989, the average price tag for $1 of earnings was $14.70. Today, that same dollar of S&P 500 earnings will cost you $28. In other words, over the past 10 years, the P/E ratio on the S&P 500 has doubled to the current lofty perch of 28 times trailing earnings.
If that valuation level gives you pause, then you'll need oxygen to handle the thin air of Rule Maker territory, where the average (mean) P/E ratio is -- you may want to sit down -- 125 times trailing earnings. At these levels, are we out of our minds to expect market-beating returns over the next decade or three?
Actually, the mean P/E of 125 overstates the middle territory of Rule Maker valuation because the mean is skewed by Yahoo!'s P/E of 799. With an outlier like that, a better measure of the middle tendency of our stocks is the median, which is a still high 48 times earnings. The data below shows the price-to-earnings, as well as price-to-free-cash-flow for each of our holdings.
Ticker Price P/E P/FCFAXP 139 11/16 27 16 CSCO 66 3/4 109 67 KO 60 7/8 48 145 GPS 39 1/8 37 82 INTC 82 1/4 39 37 MSFT 92 1/4 65 61 PFE 38 13/16 65 N/M SGP 52 9/16 40 96 TROW 31 1/2 21 29 YHOO 43 13/16 799 282 -------------------------------- Mean 125 90 Median 48 67 S&P 500 28 n/a However you slice it, our stocks are quite a bit pricier than the average S&P 500 company. And since the S&P is our benchmark for performance, we face an uphill battle to outperform the low-cost, no hassle index fund. This begs the question:
Should a prudent investor reasonably expect the earnings growth of Rule Makers to overcome their lofty valuations?
Fortunately, history offers us a very similar scenario of highly valued growth stocks. In the early 1970s, the market bid up the prices of big-cap growth stocks to nose-bleed levels. Names like Gillette, Coca-Cola, Pfizer, PepsiCo, Merck, and General Electric were said to be "one-decision" stocks because you could buy them and hold them for decades of prosperous growth. These were the world's preeminent growth companies. The valuations were high at 42x earnings, but great companies like these would surely grow earnings at a rate that would more than justify their high prices. Sound familiar?
These stocks were labeled the "Nifty Fifty." After the market peaked in December 1972, things turned rather un-nifty for these stocks. The bear market of 1973-74 cut many of these stocks in half, if not worse. Investors were disillusioned by the sell-off of growth stocks, and Wall Street became convinced that it was sheer folly to have ever bought into the idea that any stock could be worth more than 30 times earnings.
Wharton professor Jeremy Siegel recounts the Nifty Fifty era in his seminal work, Stocks for the Long Run. As detailed by Siegel, the following Nifty Fifty post mortem appeared in the December 15, 1977 issue of Forbes:
"What held the Nifty Fifty up? The same thing that held up tulip-bulb prices in long-ago Holland -- popular delusions and the madness of crowds. The delusion was that these companies were so good it didn't matter what you paid for them; their inexorable growth would bail you out. Obviously the problem was not with the companies but with the temporary insanity of institutional money managers -- proving again that stupidity well-packaged can sound like wisdom."
Wisdom, eh? In fact, Siegel's research proves the folly of such conventional wisdom. Siegel studied the Nifty Fifty returns from the market peak in December 1972 thru June 1997 (the latest date of the book's publication) and found that the subsequent annual returns of a buy-and-hold portfolio of the 50 stocks just barely fell short of matching the market's average annual return. The photo finish was 12.4% for the Nifty Fifty versus 12.9% for the S&P 500. Now, these are pre-tax returns. Siegel notes that the Nifty Fifty would've actually outperformed the S&P assuming a taxable account and tax bracket greater than 28%. See, the Nifty Fifty had a much lower dividend yield than the S&P, and thus the Nifty Fifty's returns were mostly the result of tax-deferred capital appreciation rather than annually taxed dividends.
From the market peak in 1972, the performance of several of these Nifty Fifty are particularly noteworthy to Rule Maker investors:
Annualized Return 1972 P/ECoca-Cola 17.2% 46.4 Pfizer 16.9% 28.4 Schering-Plough 13.7% 48.1 American Express 11.1% 37.7 S&P 500 12.9% 18.9
The moral is that Rule Maker investing is a winning strategy, but it demands an unswerving long-term investment horizon. Please read that sentence again. Right now, the U.S. economy is experiencing unprecedented prosperity and stock market investors are reaping the benefits. But let's not forget that in times past, boom years have ended with a bang, and hard times can last for many, many years.
The investors who dropped money into the Nifty Fifty in December 1972 had to wait until the late 1990s before the strategy proved successful. We're talking 25 years, a quarter century -- that's patience. And that's what it takes to successfully invest in Rule Makers.