Find your own ‘nifty fifty’ growth stocks

How would you like to beat the market by 15% a year? That's what one group of US stocks the nifty fifty' did during the late 1960s and early 1970s. Now Morgan Stanley's Ronan Carr reckons the conditions are ripe for a similar group of stocks to deliver again. So how can you spot them?

What were the nifty fifty?

This was the nickname given to a group of large growth stocks in America. It included household giants such as Walt Disney, McDonald's, General Electric and Polaroid. From the end of 1964 to the middle of 1972 this group outperformed the S&P 500 by an eye-popping 189% that's around 15% a year. What really stands out is the consistency of these results, notes Carr. The stocks suffered "only very modest setbacks even during the 1970 bear market".

What made this group of "one-decision stocks" (the decision being to buy and then never sell) so robust? The fact that they managed to deliver earnings-per-share (EPS) growth that was both above average and consistent over the period. Moreover, they delivered this in what was at times a pretty bleak economic environment for corporate profitability and growth: GDP growth was trending down while inflation crept higher. It was hardly surprising that the S&P 500 moved "in a sideways channel" for much of the period, even as the nifty fifty took off.

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Naturally, such a strong performance in such a weak environment led to some impressive share-price rises and eventually a bubble when the average price/earnings (p/e) ratio hit 45 times and the average price-to-book ratio (p/b see below) a heady eight times. By the mid-1970s the group was down sharply. But for over eight years they had put in a staggeringly strong performance against a backdrop that is strikingly similar to today's. As Carr says, that suggests that the "conditions are ripe [now] for genuine growth stocks to flourish". But what would today's equivalents of the nifty fifty look like?

Finding today's growth leaders

The many ways to screen for growth firms include considering their level of innovation, their pricing power and their control over a dominant franchise. But to track down firms that make the cut for a new nifty fifty, Carr suggests just three criteria to look out for. First, the firm must show accelerating sales growth (an expected increase in the rate of top-line growth in 2012). As back-up, firms should also show decent rates of EBITDA margin (see below) expansion.

The second criteria is in many ways the most important. Like the nifty fifty of the past, the modern-day bunch needs to combine a strong track record of earnings per share (EPS) growth. Morgan Stanley has looked at ten years of data and used it to estimate the probability of a quarterly rise in EPS with low levels of earnings volatility (so that you're less likely to get a nasty surprise following a good year).

Thirdly, Carr looks for developed-market companies with emerging markets (EM) exposure. That's because, over the next three to five years, despite big headwinds that include a possible Chinese credit crunch, "we expect EMs to be the major growth engine in the world" and contribute 80% of global GDP growth.

Three stocks that make the cut

Mobile power supply specialist Aggreko (LSE: AGK) passes the Morgan Stanley revenue and earnings tests and is a preferred stock for Tim Price of PFP Group, who writes the Price Report newsletter. It trades on a forward p/e of 17 (with a 75% chance of a quarterly rise in EPS). Cigarette maker Imperial Tobacco (LSE: IMT) trades on a forward p/e of 10.5 (with a 90% chance of an EPS upgrade); and consumer goods firm Reckitt Benckiser (LSE: RB) is on a forward p/e of just over 13 (and a 95% EPS upgrade rating). As Motley Fool puts it, "you are as likely to use products such as... Nurofen and Vanish in Mumbai and Marrakech as in Manchester".

What is a price-to-book (p/b) ratio?

This compares a firm's share price with the book value of its assets per share. So if the share price is £3, the firm has nets assets of £100m, and has 200 million shares in issue, net asset value (NAV) per share is 50p (£100m/200m) and the p/b ratio is six (£3/50p). That's pretty high. It suggests the firm is priced at six times the book value of the assets it actually owns (after debt has been deducted, hence the term net assets'). A p/b of below one, on the other hand, suggests the market has priced the shares below the value of a company's net assets. This ratio is best suited to asset-intensive sectors, such as property firms. Also, it depends on the accuracy of a firm's balance-sheet net assets as a guide to what it is really worth.

What is an EBITDA margin?

A margin is calculated as a chosen profit figure divided into sales as a percentage. But while there is usually little disagreement about a firm's sales number, there are a number of ways to measure profit using a firm's profit and loss account. One is EBITDA: earnings before interest, tax, depreciation and amortisation. That's operating profit, but with interest and tax stripped out (since they are not directly related to trading) as well as two highly subjective charges made to reflect the annual consumption of a firm's assets depreciation and amortisation. So if EBITDA is, say, £50m and sales are £500m, the EBITDA margin is 10% (£50m/£500m X 100%). The higher the better, provided the firm is able consistently to increase it.

This article was originally published in MoneyWeek magazine issue number 560 on 21 October 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.