For tonight's Rule Maker report, let's hop in the time machine and put a few Nifty Fifty greats under the Rule Maker spotlight. Next stop: 1972.
Most investors know about the Nifty Fifty, a group of growth stocks institutional investors loved in the late 1960s and early 1970s. The concept was simple: Buy the best companies and hold on for the long-term. Unfortunately, high inflation in 1973 took 40% off the S&P 500's value over the next two years, and many of the Nifty Fifty never recaptured their glory. High-P/E stocks such as Polaroid (NYSE: PRD), Procter & Gamble (NYSE: PG), and Revlon (NYSE: REV) fell hard.
Why bother looking in the rearview mirror? First, I wanted to know if Rule Makers are just modern-day Nifty Fifty companies. My guess was that many of the so-called one-decision stocks wouldn't finish the Rule Maker ropes course. Of the three I looked at -- Sears (NYSE: S), Avon (NYSE: AVP), and Polaroid (NYSE: PRD) -- only one cleared the hurdles. This certainly isn't definitive, but it gives me a comfort level. (To save space, I didn't run a full screen on Polaroid. Its earnings steadily declined from 1970 to 1972, enough of a red flag to exclude it from the portfolio.)
While I chose the companies at random, I was looking for dominant players that never really regained the same level of greatness. Sears, Avon, and Polaroid were high flyers, with 1972 P/E Ratios of 29.2, 61.2, and 94.8, respectively, compared to 18.9 for the S&P 500 Index in December.
Additionally, historical perspective is part of the support structure of a buy-and-hold strategy. For me, knowing a company's history fortifies my thinking, provides context, and offers shelter against doomsday predictions, errant news stories, and earnings estimates.
For example, clothing retailer Gap (NYSE: GPS) hasn't had a great year, but it's useful knowing that CEO Mickey Drexler is on the case. Remember, Drexler and his management team spotted the move away from middle-end to discount brands years ago, and created the Old Navy concept. This positioned the company for compound annual sales growth of 21% over the last five years.
While I don't consider Sears or Avon Rule Makers today, the two made deep impressions on the U.S. business landscape. Sears' far-reaching catalog and automated distribution centers gave the company a competitive advantage. Avon pioneered the direct-sales model for cosmetics companies, a move that gave it a grass roots touch and a powerful brand name.
Enough prattle. I'll give you the Cliffs Notes version for both companies.
High score for the qualitative criteria: dominant brand, repeat purchase business, convenience, and expanding possibilities. I'd give Avon high marks in these areas as well.
- Sales growth of at least 10%: Sears 9.8%. I wouldn't give the company full credit here, since its compound annual sales growth for the previous 10 years came in around 9%.
- Gross margins of 50%: Sears 38%.
- Net profit margins of 7%: Sears 6%.
- At least 1.5x more cash than debt: Sears had about 13x more debt than cash.
- Foolish Flow Ratio less than 1.25: The Sears Flow Ratio stood at about 4.2. This is, in part, because of high receivables related to its valuable credit card division.
- Cash King Margin at least 10%: This is a little tricky, since the statement of cash flows didn't exist in its current form in 1972. (It was called the statement of changes in financial position.) According to my estimate, Sears produced about $45 million in free cash flow in 1972, which isn't meaningful relative to its $10 billion in sales.
Avon is a different story.
- Sales: 15%. Compound annual growth rate of 15% from 1963 to 1972.
- Gross margins: 65%
- Net margins: 12%
- Cash-to-debt ratio: 4.2
- Foolish Flow Ratio: 1.38
- Cash King Margin: 11%
So what happened to the stock prices of Sears, Avon, and Polaroid? From December 1972 to June 1997, Sears produced an annualized return of 8.3%, Avon produced 4.7%, and Polaroid produced 1.7%, while the S&P 500 generated annualized returns of 12.9%, according to Stocks for the Long Run, by Wharton Professor of Finance Jeremy Siegel.
It's easy in hindsight to say Avon was overvalued, but investors didn't just wake up and decide to detonate its market value. First, inflation toppled the market. Everyone knows this, but it's a mistake to think this is what made all the Nifty Fifty companies bad bets in 1972.
Much more importantly, Avon failed to detect a major shift in the landscape that put its grass roots strategy on a slippery slope. Women started to enter the workforce in huge numbers, making it harder to find Avon representatives and leaving fewer women at home to answer doors. (Check out this 1996 Forbes article.) This exodus from home to work, which Avon management thought was a short-term trend, represented an inflection point Avon failed to recognize.
Sure, there was risk in Avon's 1972 valuation, as there is for many stocks in the RM Portfolio, but the critical issue is that Avon stumbled and took years to regain its footing, not simply that it was a high-priced growth stock. For me, that's the lesson to take away from Avon's not so nifty experience.
Would the Rule Maker screens have picked up on the trend? Not any of the quantitative screens, at least not until it was common knowledge. This is where one of the most overlooked Rule Maker criteria shines: Your familiarity and interest. If you're interested in a company's business, you'll stay on top of trends by reading general news stories, discussion boards, and trade reports, weeding out the wheat from the chaff. This doesn't mean you would have known Avon was heading into white water, but you might have been more attuned to the risk. If you were only interested in the stock price, Avon's error would have passed you by.
What do you think? Are there any trends brewing that could threaten our Rule Makers' dominance? Post your thoughts on the Rule Maker Strategy discussion board.
Have a great day.