Post of the Day
June 16, 1998

From our
Cash-King Strategy Board


Subject: Importance of Valuation
Author: yotommy

...the quality of a business is 1000 times more important to us than the present value of its stock. - Cash-King report, March 9, 1998 and elsewhere

Preface - I have not historically been a value hawk. Take as evidence the fact that I recently enrolled in Paychex's DRIP! Also, don't think from the beginning that this will be just another Nifty Fifty slam. Quite the contrary.

I recently purchased the exceptional book, Stocks for the Long Run by Jeremy Siegel (available through Foolmart). His main point is that the stock market not only provides the highest average returns of available investment vehicles, but over the long-term, also the safest.

Though much of the book is about the stock market as a whole, he has sections on specific strategies, including the Dow Dividend Approach, contrarian indicators and others. Everything is meticulously referenced.

He also covers the Nifty Fifty, as has previously been reported here in Fooldom. A couple of quotes for those unfamiliar with the Nifty Fifty:

"The Nifty Fifty were a group of premier growth stocks ... which became institutional darlings in the early 1970s... The Nifty Fifty were often called one-decision stocks: buy and never sell."

The Nifty Fifty have been derided for selling at unreasonable multiples, prices that could not possibly be justified in terms of future returns. However, Siegel's analysis showed that buying the Nifty Fifty even at the "height of the ... mania" was not such a bad long-term investment. Indeed, buying equal portions of the Nifty Fifty stocks in December 1972 and holding until June 1997 would have returned 12.4% annually, while the S&P500 would have returned 12.9% over the same period. (The numbers improve slightly with monthly rebalancing.)

Wow! Not bad for one-decision. And if you eliminated a few dogs over the years (three of the fifty had negative returns over the period), it wouldn't have been hard to beat the S&P 500.

There are of course some similarities between the Nifty Fifty and Cash Kings, which is why I post this message here. Because as Siegel puts it,

"there is a value-oriented theme hidden in the dazzle of these growth stocks... the 25 stocks with highest [P-E] ratios [when purchased] yielded only about half the subsequent return as the 25 stocks with the lowest P-E ratios."

At this point I'll use Siegel's data for my own calculations. I attempted to make a very simple model of the annual return of the components of the Nifty Fifty: annual_return = r0 + alpha * (P/E). Using Siegel's data for annual_return and P/E, I calculated the linear regression and got this result:

annual_return = 17.2% - 0.18% * (P/E)

On average, for each 10 point increase in P/E (purchase price), the subsequent annual return decreased 1.8%.

How well did this too-simple model match the data? Fair question. In statistical terms, the R-squared was about 0.25, meaning that this single factor accounted for about 1/4 of the variation between the individual stocks. We all know that there are many factors which influence returns. A glance at the scatterplot ( http://www.serve.com/tsmith/nifty50.html ) shows that there are certainly some stocks that had high P/E ratios and excellent subsequent returns. KO is an excellent example (1972 P/E: 46.4, annual return of 17.2%).

So a call for us Cash-Kingers: we must strive to find the stocks that will be near the top of this graph twenty-five years from now! But if the history of the Nifty Fifty has any lesson, it may be easier to have above-average returns by buying stocks with lower current valuations.

To return to the opening line from this posting for a moment... Considering that the simple model above shows that current valuation "explained" 1/4 of the variation in return of Nifty Fifty stocks, there is still 3/4 not accounted for. So the fictional writer of the "Nifty Fifty" Port report might have written:

...the quality of a business is up to 3 times more important to us than the present value of its stock.

Fool on!
yotommy


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