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  • Writer's pictureVertium Asset Management

Echoes of the Nifty-Fifty bubble

Quality investing, a strategy focused on companies with strong financials and consistent performance, has become a dominant force in recent years. Pioneered by academics like Novy-Marx (2013), it was shown that high-quality stocks with stable earnings, strong balance sheets and healthy profit margins typically outperform low-quality stocks. This strategy gained significant traction in the investment world, with numerous exchange-traded funds (ETFs) launched to mirror the performance of quality companies. Even active fund managers have jumped on the bandwagon, rebranding themselves as quality focused.


Quality investing is not a new concept. It is essentially an extension of "blue-chip" investing, which focuses on established companies with a long history of reliable performance. While quality investing has delivered impressive results in recent decades, the early 1970s stock market bubble serves as a cautionary tale. Back then, investors became enamoured with a group of blue-chip companies, which were nicknamed the ‘Nifty Fifty’. Unlike the Dot-com bubble fuelled by unprofitable companies, the Nifty Fifty were highly profitable but became dangerously overvalued.


The genesis of the Nifty Fifty bubble began in the late 1960s when the market grappled with economic turbulence. Inflation, dormant for more than a decade, surged to 6% by 1970. This, coupled with a bear market was particularly brutal for small cap stocks. Investors, seeking stability, flocked to blue chip companies perceived as safe havens. These companies boasted resilient earnings growth and were household names like IBM, Coca-Cola, and McDonald’s.


Consider McDonald’s. In the five years leading up to 1972, the company delivered 38% annual earnings growth.  This stellar performance propelled its share price, culminating in a staggering price-to-earnings (PE) ratio of 60x in late 1972. MacDonald’s future prospects did not disappoint. Profit growth was uninterrupted at 24% per annum for the next decade – a feat even more remarkable considering the recessions of the mid-1970s and early 1980s.


McDonald’s share price and profits (1967 – 1981)


Source: FactSet, Company accounts


However, despite MacDonald’s impressive earnings resilience, it’s share price halved within two years of its peak, taking nearly a decade to recover. Even investment legends were not immune. The late Charlie Munger, who shaped Warren Buffet’s shift towards quality investing, was caught in the Nifty Fifty’s demise in 1973 and 1974.


Munger Partnership performance (1962 – 1975)



Today, eerie parallels are emerging between the Nifty-Fifty and the current market landscape. Inflation has reared its head once again, reaching a worrying 9% in 2022. The speculative boom and bust of small-cap stocks around the COVID pandemic has made investors wary. Additionally, the looming debt refinancings raises the risk profile for many small companies.


With high levels of market anxiety, the market has gravitated to two themes. Some investors are chasing the artificial intelligence boom, exemplified by Nvidia with its explosive earnings growth.


Nvidia’s share price, EPS and PE multiple (2019 – 2024)


Source: FactSet


On the other hand, cautious investors seeking refuge from volatility are gravitating towards low-risk havens. However, higher interest rates have dampened investor appetite for traditional defensive sectors like Real Estate Investment Trusts. Consequently, the opportunities for ‘safe haven’ investments have shrunk leading to greater demand for high-quality stocks.


Costco, a world-renowned retailer, serves as a prime example of this phenomenon. Costco is renowned for its loyal customer base which fuels predictable, reliable and consistent financial performance. Despite its ordinary growth profile, Costco’s share price has ballooned, currently at a record PE ratio of 50x. Remarkably, this PE ratio is more than double what it was when Costco was experiencing significantly higher earnings growth rates two decades ago.

 

Costco’s share price, EPS and PE multiple (2002 – 2024)


Source: FactSet


Procter and Gamble, another example, the world’s largest consumer staple company that owns brands like Gillette and Oral-B also exhibits elevated valuations. While its valuation is not as extreme as Costco, its PE ratio is hovering near its twenty-year highs.

 

Procter and Gamble’s share price, EPS and PE multiple (2002 – 2024)


Source: FactSet


This trend extends beyond the US market. In Australia, Commonwealth Bank (CBA) is considered the highest quality bank due to its superior return on equity. Like Costco, CBA’s share price has surged, pushing its PE ratio to reach a 20 year high. This is particularly surprising given its stagnant earnings growth since 2015 due to intense competition in retail banking. Yet, CBA’s PE ratio boasts a 50% premium compared to its historical average.

 

Commonwealth Bank’s share price, EPS and PE multiple (2002 – 2024)

Source: FactSet

 

Wesfarmers, another prominent Australian blue-chip company, with dominant industry positions with Kmart and Bunnings also exhibits similar valuation concerns. Its PE ratio is currently trading at similar alarming levels observed during the COVID pandemic market bubble.

 

Wesfarmers’s share price, EPS and PE multiple (2002 – 2024)


Source: FactSet

 

While quality investing offers undeniable merits, the Nifty Fifty bubble serves as a cautionary tale where exceptional companies with robust fundamentals can be poor investments when valuations become unanchored from reality. In today's market, with echoes of the past, there is a danger that quality stocks are being chased at a premium. If history rhymes, then quality at any price could be as disastrous as indulging in overvalued, speculative bubbles.


Disciplined valuation analysis remains paramount to ensure quality translates into robust investment returns.

 

Reference:

Novy-Marx, R., The Other Side of Value: The Gross Profitability Premium”, Journal of Financial Economics, 108 (2013), 1 – 28.

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