In recent years, the valuations of a group of well-known companies have been relatively high due to their strong competitive advantages and their history of sustained and steady growth. However, in a competitive economy, investors should not expect this to last forever.
They say that interest rates are like gravity in the financial world. When rates are high, stock prices should be lower because they reduce the present value of future cash flows that stock investors demand. The reverse is also true: when rates are low, stock prices should be higher.
In December, the Bloomberg Barclays Global Negative Yielding Debt Index outstanding reached a new all-time high of $ 18 trillion, eclipsing the previous $ 17 trillion of August 2019.
It is therefore not surprising that many investors seeking performance in this difficult environment conclude that there are few alternatives to equities. Unlike the dot-com bubble or the real estate bubble before the global financial crisis, the speculative excesses that this engendered are not limited to one industry or sector. The frenzy is more subtle, rather reminiscent of the “Nifty Fifty” era in the 70s.
The “Nifty Fifty” were a group of big star companies that became real darlings in the 1960s and saw their valuations soar in the early 1970s before falling sharply during the bear market of 1973-74. Although the list was not exhaustive, everyone at the time knew who these companies were, because they usually had certain characteristics in common: a reputation for quality and reliability, demonstrated by their ability to remain profitable in both boom and bust, as well as proven growth rates and a continuous increase in their dividends.
Fifty years later, most people are still familiar with these familiar brands of Disney, McDonald’s, Procter & Gamble, PepsiCo, Coca-Cola, Pfizer and Johnson & Johnson. These, and others, were considered ‘one-time’ stocks, which could be bought and held indefinitely because their prospects were dazzling and their price-to-earnings ratios (PER_Price Earning Ratio) of 30, 40, or even 70. were more than justified.
In a sense, buyers were not mistaken: an equally-weighted model portfolio would outperform over the next thirty years. Corporate fundamentals have finally caught up with valuation levels. But the difficulty for portfolio managers was that, in the interim, they would have experienced steep relative declines for two decades.
Today, a new legion of “Nifty Fifty” is preparing. As before, there is no exhaustive list, but the characteristics are: well-known companies that have strong competitive advantages, strong and steady profitable growth and whose PERs have been driven up. Skeptics can search for the hashtag #neversell on social media.
A selection of companies listed in the UK, but also in Europe and America, has enriched a generation of clients investing in “quality growth” funds that it is difficult to blame their managers for continuing to hold them.
We can only wonder why the “Nifty Fifty” are back. Perhaps, deprived of bond yields, investors are looking for alternatives to bonds. Or maybe there is a group of professional investors who have primarily practiced during a time when strategies based on poor quality statistics have inexorably underperformed, who are wary of low PERs and are reassured by high multiples. Unless the efficiency of the market lies beyond the formulation of medium-term, above-average earnings forecasts, and lies in the value of discounted cash flows, where most of the value resides.
Market historians have observed that stocks generated an annualized return of around 8%. (1) If we know the starting multiple and take 8% as the opportunity cost, then we can infer the growth rate. implied valuations at the moment. So, to get an 8% asset performance from a 2% starting free cash flow return, that cash flow must grow 6% per annum indefinitely. However, this is a lot of time in a competitive capitalist economy with the constant risk of disruptive obsolescence.
It remains to be seen whether the companies we are talking about are able to achieve this indefinitely, which is required by the current level of their stock valuations.
Stocks look cheap if long-term interest rates stay low for the next four or five years, but relative valuations are not uniformly attractive in the market, however. The question is not to know precisely what is the valuation of #neversell shares: for some, the challenges that prevent them from reaching a level close to their historical performance can be insurmountable, and even the fact of exceeding a performance rate. equivalent on the equity market could prove difficult. Therefore, investors should look to other companies; companies with positive cash flow and long-lasting competitive advantages, whose valuation multiples are more reasonable for equally attractive growth prospects.
Past performance is no guarantee of future performance.
1. Elroy Dimson, Paul Marsh, and Mike Staunton, “Research Institute: Summary edition Credit Suisse global investment returns yearbook 2020”, Credit Suisse, February 2020