A scene from Toronto in the 1970s, when Nifty Fifty stocks dominated U.S. institutional investments.JOHN McNEILL/The Globe and Mail
I entered the investment business in 1971 when it was definitely a male-dominated profession, especially the sell-side. As a result, some of the favourite expressions of the time would not pass muster today.
I recall listening to salesmen from companies that no longer exist tossing back a martini or two at Winston’s steakhouse in Toronto and pronouncing, “When the police raid a bawdy house, they arrest all the girls.” By that, they meant that when a bear market occurs, all stocks go down, even those that were touted as being defensive.
Today’s MBA-driven market gurus would say “in a bear market all correlations go to one,” but the message is the same.
I bring up this anecdote because a number of commentators, myself included, have suggested that prudent diversification will avoid the pain of the coming correction in the market that has been forecast ad nauseam. My experience of the seventies suggests that diversification better positions your portfolio for the recovery phase but does not avoid pain in the short term. Let me explain.
By 1973, I had been promoted to the position of portfolio manager of a small U.S. equity fund at Confederation Life Insurance Company. Better known as Confed, it was the hotbed of Ben Graham-style value investing and proved to be the birthplace of several value shops.
At that time, however, the Nifty Fifty stocks dominated the U.S. institutional-investment scene. Small-cap value portfolios were serious laggards and we struggled to retain clients. There was never any formal definition of the Nifty Fifty stocks, but they all had strong balance sheets, attractive growth prospects and extravagant price/earnings multiples.
The other name for them was “one-decision stocks,” meaning that you just bought them and never had to decide if they were fully valued and therefore sale candidates. Sound familiar?
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What is familiar to me is the argument that today’s U.S. market is not a bubble because the current crop of mega-cap stocks are all legitimate businesses with strong, liquid balance sheets and great growth potential.
A derisive comparison is often made to the internet stocks of the late nineties that had no earnings or even revenues but simply a business model ending in dot-com. No wonder they imploded with no residual value.
This is a valid point, but in contrast, the Nifty Fifty stocks were not all marginal operators. In fact, many of them still exist today: American Express, Bristol Myers, Coca-Cola, IBM, 3M, Merck, Schlumberger, Walmart.
A few – like Avon Products, Eastman Kodak, JC Penney, Polaroid − are a shadow of their former selves because their product offerings no longer resonated with the customer, not because the company was a house of cards. In other words, the Nifty Fifty stocks were priced for perfection, and no amount of growth could sustain the valuations embedded in the price.
When the U.S. market fell off sharply in 1974, our value-oriented portfolio fell by essentially the same amount as the big-cap index. The only difference was that the value and small-cap sector recovered strongly for the remainder of the decade while the Nifty Fifty constituents lagged the market over the same time period.
If the Nifty Fifty era of the seventies is a better analogy than the dot-com bubble of the late nineties, what valuation parameter should you employ to identify overvaluation in today’s market? Ironically, my preference is to follow the lead of Scott McNealy, then-CEO of Sun Microsystems who made the following comments in spring 2002, two years after the dot-com bubble imploded:
“Two years ago, we were trading at 10 times revenue. … At 10 times revenue to give you a 10-year payback, I have to pay you 100 per cent of revenues for 10 straight years in dividends … that assumes zero cost of goods sold, which is very hard for a computer company.
“That assumes zero expenses, which is really hard with 39,000 employees. That assumes that I pay no taxes, which is very hard. … And that assumes that with zero R&D for the next 10 years, I can maintain the current revenue run rate.
“Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
Sun Microsystems struggled for the next few years and finally agreed to be acquired by Oracle Corporation in January, 2010 for US$9.50 a share, valuing the company at US$5.6-billion, less than half the recent revenue run rate of US$14-billion. At the peak of the dot-com bubble, the stock had traded as high as US$250.
My case rests on the logic that once investors start to pay extravagant multiples of revenues for a company, there is no margin for error. The good news is that comparing market capitalization with revenues is a simple calculation for any investor. As Mr. McNealy said, “You don’t need any footnotes.”
A more comprehensive analysis of the dangers of investing in high price to sales ratio stocks is set out by James P. O’Shaughnessy in his 2012 book What Works on Wall Street, which covers U.S. stocks from 1963 through 2009.
In a section ominously headed: High PSR Stocks Are Toxic, he states: “… the dubious honor of worst performance to date goes to the decile (10 per cent) with the highest price to sales ratios from the All stocks universe.”
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.