Equity Duration & Inflation: Lessons from the Nifty Fifty
This is Part III of a three-part series. Read Part I here and Part II here.
In the early 1970s, a group of high quality growth stocks such as Coca-Cola, Procter & Gamble, Johnson & Johnson, Walt Disney, American Express, and Pfizer generated gangbuster returns. At the time, these stocks were referred to as the Nifty Fifty. At their peak in late 1972, these stocks traded at a PE ratio of 42x while the overall S&P 500 was trading at a PE of 19x. But in 1973 and 1974, inflation rose rapidly, a recession hit, the overall market declined, and Nifty Fifty stocks underperformed sharply.
Most investors think of the collapse of the Nifty Fifty stocks as a bubble that burst. But in fact, if you had bought these stocks at their all time highs and hung on for the long term, you would have earned a 12%+ annual rate of return, or the same as the overall market.
If these stocks proved they were not in a bubble by generating strong returns even from peak valuations that were more than double the overall market valuation, why did they perform so poorly during the 1970s and then perform so extraordinarily well in subsequent decades? And what does this history tell us about today’s market, where high quality growth stocks have traded down by so much this year after trading at relatively high valuations at the end of 2021?
First, let’s step back and review where stock returns come from and how we can prove in retrospect whether a stock was overvalued and by how much.
A stock’s return can be broken down into three drivers:
- The growth of earnings over time.
- The starting and ending PE ratio investors pay for those earnings.
- The dividends the stock pays out.
So, if earnings grow at 10% a year for a decade, a stock starts with a PE ratio of 25x and ends the decade with a PE ratio of 20x, and dividend payments add 1.4% per year to returns, the stock will generate a return of 9% or the long-term average rate of return for stocks.
|Year 1||Year 10|
10-year annualized stock price return: 7.6% + Dividend Yield of 1.4% = 9%
If 9% a year is the fairly valued rate of return for the stock in question, then we know in retrospect that the stock was fairly priced 10 years ago when it was trading at a PE of 25x. If it had been trading at a PE of 16x, it would have returned 14.7% a year – a very attractive rate of return – and thus, we would know that it had been trading at too cheap a price. If it had been trading at a PE of 35x, it would have returned 5% a year – a very weak rate of return – and thus, we would know that it had been trading at too expensive of a price.
In January of 2021, we wrote about this approach to retroactively demonstrating fair value. Our analysis in that post showed that while Costco traded at a median PE ratio of 15x between 2002 and 2015, it was actually worth a PE of closer to 40x. The fact it traded so cheaply is why the stock generated returns of 15%-20% over that time period. If you had paid as much as 40x, or twice the highest market valuation the stock obtained over that time period, you still would have earned a 9% rate of return.
Professor Jeremy Siegel of the University of Pennsylvania ran this type of analysis on the Nifty Fifty to generate the following chart.
What the chart shows is that while the Nifty Fifty stocks underperformed during the 1970s after their 1972 peak, they subsequently generated outstanding returns that fully reversed all the prior underperformance. Thus, in retrospect we know that the Nifty Fifty stocks as a group were not overvalued in a material way.
In this next chart, Siegel shows the members of the Nifty Fifty along with their annualized rate of return from the 1972 peak, their peak PE ratio and the PE ratio investors could have paid and still earned the same return as the S&P 500. His methodology for determining in retrospect what the actual fair value PE was is identical to the approach we explained in our post on this topic using Costco as an example.
The data shows that while Coca-Cola’s PE ratio at the end of 1972 was 46x, a huge premium to the S&P 500 PE ratio of 19x, Coke still went on to generate a 16.2% annual rate of return, beating the S&P 500’s 12.7% rate of return and demonstrating that Coke was actually cheap at 46x earnings. In fact, investors could have paid as much as 82x earnings, an eye popping PE ratio, and still have generated returns in line with the overall market.
Of course, not all the members of the Nifty Fifty did so well. Xerox also traded at 46x earnings, but it went on to generate annual returns of just 6.5%, far less than the S&P 500. The chart shows that investors would have had to pay no more than 19x earnings to generate the same returns as the S&P 500.
Why did Coke do so well, while Xerox did not, despite both trading at the same, optically high, PE ratio? The answer is in the far-right column of the chart where you can see that Coke grew earnings at 13.5% a year over the time period measured while Xerox grew earnings at just 5% a year.
In retrospect, we know that the Nifty Fifty stocks as a group performed just fine even from peak earnings multiples of more than twice the valuation of the S&P 500. Many members of the Nifty Fifty went out to produce gangbuster, multidecade returns even if you bought them at peak valuations before they temporarily collapsed.
So, if they were not overvalued, why did they underperform so badly during the 1970s, and why did their performance turn around in 1980 to begin a period of massive outperformance that recovered all of their prior underperformance?
The reason was the stagflation that began in 1973 was not fully brought under control for a decade. The chart below shows the rate of inflation (the white line), the level of the S&P 500 (blue line), and the three recessions that occurred over the 10-year period (red shading).
What the chart shows is that the overall market fell very dramatically from 1972 through 1974, during which time inflation raced up to over 12% and the economy entered a prolonged recession. But once inflation peaked, and began to decline, the market rallied dramatically. However, the victory over inflation was not complete and it was relatively short lived. Inflation at the end of 1976 had only retreated to 5%.
By 1977, inflation was rising again and this time it was embarking on six-year period of high inflation that reached 15%. To finally bring inflation back down to more sustainable levels, Fed Chairman Paul Volker pushed the Fed Funds interest rate to an incredible 20%, triggering two back to back recessions that lasted for a total of three years.
Over the 10-year period from 1972 to 1982, the overall market returned 6.7% per year while Nifty Fifty stocks did even worse. The PE ratio of the overall market averaged just 9x, with Nifty Fifty stocks retained premium multiples, but at low absolute levels in the mid to low teens.
But once inflation was beaten, the market began a huge multidecade bull run, with Nifty Fifty stocks leading the way and eventually recouping all their underperformance from the stagflationary decade.
The lesson is clear. When inflation rises to high levels and investors come to believe that inflation will remain high for a long period of time, PE ratios fall sharply with the valuations of long duration growth stocks falling by more than average. But once inflation begins to retreat and investors come to believe that it will remain at lower levels on a sustainable basis, valuations quickly reset to higher levels, with the valuation of long duration growth stocks leading the charge higher.
The recovery of long duration, growth stock performance did not wait for the victory over inflation to be final. Rallies in the 1970s occurred once inflation began trending down even as it remained at high levels. By 1985, inflation was still running at nearly 4%, yet the equity market had doubled over the past three years, with Nifty Fifty stocks doing even better.
In early March of this year, as the first wave of selling of high quality growth stocks reached an initial crescendo, we wrote an extensive post arguing that the underperformance of the high quality growth stocks in our portfolio was due primarily to a panic about stagflation sweeping the market. While the valuation of the overall market has declined this year, the valuation of long duration growth stocks has declined by far more.
So where do we go from here?
High levels of inflation, and particularly stagflationary conditions where inflation remains high even in the face of recessionary levels of economic growth, are a very rare occurrence in the US and most all developed markets. We referred to stagflationary worries in early March as a “panic” not because there is no reason to be concerned about inflation or a recession (investors have good reason to be worried about both), but because as of today, we have yet to experience a recession and inflation has only been high for 15 months. The “panic” is about worries that these conditions are bound to persist for many years.
The lessons of the Nifty Fifty, and broader equity market returns from the 1970s, are not that the Nifty Fifty was a stock price bubble (it wasn’t), nor was it that once you get inflation, you are doomed to low valuations and weak equity returns for many years.
The lesson of the 1970s is that when equity investors come to believe that inflation will persist for many years, valuations contract dramatically and stay low until such time that investors come to believe that inflation will trend back to more normal levels over time. Once those beliefs shift, equity market valuations come screaming back to more normal levels.
During periods when this happens, high quality growth stocks that have long duration, which justifiably trade at elevated valuation multiples in normal times, see even more multiple compression than the average company. But the elevated multiples these types of companies trade at during more normal times are justified (as demonstrated above with the Nifty Fifty example). So, as long term inflation expectations return to more normal levels, long duration, high quality growth stocks see rapid valuation multiple expansion.
The key for investors like us who invest in a focused portfolio of stocks, is to do our best to own those high quality growth companies that deliver on providing long-term growth. As the chart earlier in this post shows, those Nifty Fifty stocks such as Coke that delivered on growth expectations not only did as well as the market from peak, pre-inflation valuations, they went on to do much better than the market. While those Nifty Fifty stocks such as Xerox that failed to deliver on growth expectations ended up doing much worse. Even though Xerox and Coke exited 1972 with the exact same PE ratio.
The Ensemble portfolio is not made up exclusively of long duration growth stocks by any means. But the long duration growth stocks we do own are responsible for the majority of our year-to-date underperformance vs the S&P 500.
If the US economy is embarking on a decade of rolling recessions and 10% inflation, as was experienced in the 1970s, then the long duration growth companies of today will take a very long time to generate satisfactory returns from the price levels they traded at as of the beginning of this year. But should we avoid the catastrophe of the 1970s, should we bring inflation back under control in the next year or three, even if doing so requires triggering a recession, the valuation pressure will come off of long duration growth stocks and those that deliver strong long term growth will prove to have been trading at extremely attractive prices today.
It was not a bubble in growth stocks that caused the Nifty Fifty stocks to fall in value in 1973-74. And it was not a year or three of elevated inflation that caused broader equity market returns to be so poor in the 1970s. The issue was our country experienced a horrendous decade of rolling recessions every few years even while inflation ran at between 5% and 15% for 10 years in a row.
Investors are right to look to the 1970s for lessons to learn about navigating today’s financial markets. But it is critical to distinguish between the core lessons about how financial assets trade during periods of extended, elevated inflation, vs simplistically assuming that any bout of extended, elevated inflation somehow kicks off a replay of the 10-year economic period that happened to play out in the 1970s.
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