Investors should know about this market crash
New investors might not be familiar with the lore. Here’s a deep dive into the lessons we can learn.
The first in this series explored the .com crash. This is the second of a three-part series of market crashes, and what investors can learn from them.
The premise of this market crash series
I came into investing later than my older colleagues. I haven’t experienced major market events to any real extent. I was in high school during the Global Financial Crisis and had no dog in the fight. I do have some advantages over investors my age. I get to spend my workday reading and gaining an understanding of these infamous events. I try and get a sense of how investors reacted and the chain of events that led us to where we are today.
An influx of new people have joined the ranks of investors in the last decade as barriers have been lowered. They’re in the same boat. They don’t know the ‘lore’ of large market events and the crucial lessons that they taught investors.
Markets go through periods of euphoria and despair, and investors who understand these cycles, not just academically, but emotionally, are the ones that are able to build lasting wealth.
It is hard to replicate the experience of living through a full cycle. But it is worth understanding a few of these major market events that have become part of investing lore, and what they can teach us about becoming resilient investors.
This is the second of a three-part series into market crashes and what investors can learn from them.
The Nifty Fifty
The Nifty Fifty was a market run during the 1960s and early 1970s, followed by a bear market in 1972 and 1973. The Nifty Fifty itself was the name given to a group of US growth stocks with high returns becoming symbolic of the spirit of the times. The companies included household names like McDonald’s, Coca-Cola, Pepsi, Johnson & Johnson and Pfizer just to name a few. The product lines range from drugs, computers and electronics to photography, food, tobacco and retailing.
Notably absent are the cyclical industries: auto, steel, transportation, capital goods, and oil.
These were established and successful companies. They grew quickly and had strong balance sheets. As the bull market continued, they became known as one decision stocks – they could be purchased at any price and never sold.
As the market continued to climb, valuation levels rose. By the end of 1972, the average price to earnings (P/E) of the Nifty Fifty was 41.9, more than double the S&P 500, which sat at 18.9. Over one-fifth sported P/E ratios in excess of 50. Polaroid was selling at over 90 times earnings. Investors chose to ignore the valuation levels because markets continued to rise.
Life was good in the late 1960s. As markets went up, more people became interested in investing. It was easier for these investors to access managed funds rather than individual securities. Fund managers became the rock stars of the investing world.
From 1960 to 1965, assets in managed funds in the United States doubled. From 1965 to 1970, they doubled again, peaking in 1972. By the end of the 1960s, there were seven times as many Americans that held shares than during the height of the 1929 bubble.
In 1972, inflation started to rise as the US government financed huge budget deficits. The market started going south in 1973 and 1974. It was the worst downturn since the Great Depression. Investors saw the S&P 500 go down 42%. The market took almost 6 years to recover.
It wasn’t just US markets. This downturn effected all global markets, some much more severely than the US. The UK market didn’t recover for over 13 years.
At the centre of this downturn was the Nifty Fifty. From their highs, some of the share price declines to 1974 lows were eye-watering.
Jeremy Siegel, a Professor at the Warton School at the University of Pennsylvania conducted a study in 1998 to look at what happened to the Nifty Fifty. He explored the performance of the 50 shares between December 1972 – the peak of their bubble – and 1998. He found that both on an equal-weighted basis with rebalancing, and an equal-weighted basis without rebalancing, the Nifty Fifty stocks performed close to the index (the S&P 500) over that time frame.
The S&P 500 returned 12.7% a year, the rebalanced portfolio performed 12.5% a year and the non-rebalanced portfolio performed 12.2% a year.
This brings us to the first lesson from the Nifty Fifty. As investors, we want to own great companies. Unlike many bubbles that are more speculative in nature (see the .com bubble, the first part in this series), this bubble involved great companies that became overvalued. These were all established companies that were growing quickly and had strong balance sheets. Many of these companies have moats, or sustainable competitive advantages.
Morningstar was established in 1984, so we’re unable to look at historical moat ratings. This list is filled now with moat ratings. Out of the top 10 best performers during this time period, 9 of them have wide moats – Phillip Morris, Pfizer, Bristol Myers, Coca-Cola, Merck, Pepsi, Eli Lilly, Proctor & Gamble and Johnson and Johnson. One had a narrow moat, General Electric.
Companies with moats are able to maintain a competitive advantage which supports higher profit margins and market share over long periods of time. Moats allowed these companies to weather the storm. These are the companies that we want to own as investors.
We saw this in Jeremy Siegel’s study. The Nifty Fifty companies grew earnings at an average of11% between 1974 and 1998. That compares to an overall earnings per share growth rate of 8% for the index.
The 3% higher growth rate in earnings compounds.
This difference in growth rate matters. At 8% growth, a dollar of earnings would grow to $6.24 in earnings. At 11%, the dollar would grow to $12.34. Assuming there is no change in the earnings and multiple investors are willing to pay for those earnings, the return is 93% higher for the faster growing companies. Even with the big drop in valuation levels on these stocks from 1972 to 1998, they still earned a return that was close to that of the index.
As investors we want to buy great companies. Great companies are those with sustainable competitive advantages. Finding those great companies that grow at higher rates than the market over decades is the way that we can compound our wealth over the long term. However, there is another side to this equation – the price that we pay. We want to ensure that we don’t buy too high. Great quality companies are always going to be more expensive on a relative basis.
The run up during the 1960s demonstrated that principle. Great companies were worth owning. The problem came when valuation levels got too high. Great companies aren’t worth owning at any price.
This naturally leads to the second lesson for investors – it is paramount to your success to buy the high-quality companies at a compelling price.
Final thoughts
It can be hard to do something sensible – not paying too much for great companies – when the market keeps going up. It is hard to consider valuation levels in the face of positive reinforcement comes each day from rising markets.
The feeling that long bull markets elicit is why greed drives markets well past what they are worth. Successful investors have a plan, including a wishlist. This wishlist is a list of quality companies that they want to own and fits with their investment strategy. This list should include a reasonable price that you are willing to acquire this company, including an adequate margin of safety. Maybe that is the best lesson from the Nifty Fifty – being patient and waiting for valuations to come down would have been the biggest windfall for investors.
This is the second of a three-part series on defining market events and what they teach us about building wealth. The next part will be released in a fortnight, focusing on the Global Financial Crisis.
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