The 'nifty fifty' - when it makes sense to buy at the top

Investors are usually advised to buy low, sell high. But does it ever make sense to buy a pricey looking stock? The answer, say strategists at Socit Gnrale and Morgan Stanley, is yes'. To find out why, we have to go back in time a few decades.

The Nifty Fifty

The 1960s and early 1970s were the heyday of the Nifty Fifty'. This was a group of large, fast-growing firms that offered spectacular share-price growth despite soaring inflation and a stuttering economy. This was a decade that saw the main American stockmarket, the S&P 500, suffer three earnings recessions (where earnings fell for two quarters in a row), as Morgan Stanley's Ronan Carr points out.

Yet this group of blue-chip giants which included General Electric, McDonald's and Walt Disney beat the wider market by a staggering 15% per year.

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That's the sort of performance most investors would more readily associate with tiny start-ups, not established behemoths. Moreover, many of these stocks were hardly cheap to begin with. Yes, eventually the Nifty Fifty soared too far and returned to earth with a bang, causing pundits to write the whole thing off as a bubble. But they may have spoken too hastily, as we'll see in a moment.

So why are we talking about this now? Because today's investors again face a world of little or no growth, and one in which inflation looms large as a potential hazard, even if it has yet to take off in the style of the 1970s.

This nasty combination sets the scene for a new Nifty Fifty to flourish, reckon both Carr and analysts at Socit Gnrale. And a study carried out in 1998 by Jeremy Siegel for the American Association of Individual Investors shows why the new Nifty Fifty could be a solid long-term investment.

The bubble that never was

When the Nifty Fifty peaked in 1972, then dropped in price, Forbes magazine argued that the "temporary insanity of institutional money managers" had driven up stock prices to "daft levels it was so easy to forget that probably no sizeable company could possibly be worth over 50 times normal earnings".

But with the benefit of hindsight, Siegel disagreed. Forbes was clearly wrong. Yes, the Nifty Fifty ended up selling at "hefty multiples" as ever more investors piled in. The average price/earnings (p/e) ratio for the stocks involved was 41.9 in 1972, more than double that of the S&P 500's 18.9. The dividend yield also slid to 1.1%, half that of the wider market average. And sure enough, some of them met sticky ends camera group Polaroid being a prime example.

However, many others went on to offer serious growth even after they hit their valuation peak in December 1972. Tobacco firm Philip Morris. Drugs giant Merck. Coca-Cola. Gillette. Each of these stocks went on to beat the S&P 500 for years. Philip Morris in particular offered returns averaging 18% for the next 26 years.

So Siegel posed a question. If investors had known just how well these firms would perform in the future, what p/e multiple should they have been willing to pay to own these stocks in 1972? The answer in many cases is a lot more than they paid even at the valuation peak.

For example, in 1972, you could have paid as much as 68.5 times earnings for Philip Morris, and you would still have matched the return on the S&P 500 over the 26 years to 1998. Yet those who bought the stock in December 1972 paid just 24 times earnings. Coca-Cola was worth 82 times earnings and Merck 76 times, again far higher than their actual peak p/es.

Taken as a whole, even if you include the duds, the Nifty Fifty matched the returns from the S&P 500, yet were rubbished by many at the time.

There's a pattern to Siegel's 1998 findings that remains relevant today. The stocks that were cheap in 1972 based on their subsequent total returns were largely big, consumer-facing brand names, whereas those that investors were right to dump were technology-focused. That's a familiar warning for anyone who remembers the late 1990s dotcom bubble.

It also explains why the likes of Apple don't make today's Nifty Fifty lists. Siegel's message is that even relatively expensive large caps can still make sense provided you target the right ones. "Good growth stocks, like good wines, are often worth the price you have to pay." But which are they today?

The new Nifty Fifty

Certain attributes give a stock Nifty Fifty (or in the case of Socit Gnrale, Nifty Fifteen) potential. First, it needs to have strong pricing power (a decent brand, in effect) and to have delivered consistent sales and earnings growth over at least five years. It must also be financially strong Morgan Stanley favours a Piotrowski score of seven or more out of nine.

Next, it must offer a decent dividend yield (3% or above), as well as a track record of dividend growth and scope for more. Lastly, as emerging markets are the likely engines of future global growth, exposure of at least 40% of sales is ideal.

The names that top Morgan Stanley's and Socit Gnrale's lists and which stand out to us are Imperial Tobacco (LSE: IMT), drinks giant Diageo (LSE: DGE) and biotech Syngenta (VTX: SYNN).