Investing Strategy: Swap Up

by | Oct 17, 2002

You probably know the old joke: “How do you make a small fortune in the stock market?” “Start with a large fortune.” After three years in which the market has lost between a third and a half of its value (depending on your favorite index), this bit of humor hits too close to the bone. […]

You probably know the old joke: “How do you make a small fortune in the stock market?”

“Start with a large fortune.”

After three years in which the market has lost between a third and a half of its value (depending on your favorite index), this bit of humor hits too close to the bone. The truth, however, is that there is a way to make a small fortune in the stock market: Buy great companies in their youth.

For example, Intel Corp. (INTC), the semiconductor manufacturer, has fallen by more than half this year, but if you had bought the stock in 1987, you would still have made 30 times your money. Fifteen years ago, Microsoft Corp. (MSFT) earned $72 million in profit on $346 million in sales; last year, the software company earned $8 billion on $28 billion in sales. Since 1987, Microsoft’s stock, like its earnings, has risen by a factor of about 100.

Finding winners when they’re in the cradle (or even in adolescence), however, is no easy matter. Instead, consider this second, more practical route to a small fortune: Buy great, established companies when they are cheap. Such opportunities do not present themselves often, and when they do, most investors are too frightened to act. It’s time to overcome your fears.

Today, in fact, quality-stock bargains abound. In a bull market, stocks such as Merck & Co. (MRK) and Wal-Mart Stores Inc. (WMT) appear unaffordable, so investors settle for cheaper, lesser commodities. But in a bear market, the situation reminds me of Jimmy Carter’s old theme, “Why not the best?”

Where to begin? A few years ago, Richard Bernstein, the chief U.S. strategist for Merrill Lynch & Co., divided the 500 stocks of the benchmark Standard & Poor’s index (roughly America’s 500 largest publicly traded firms) into two groups, according to market capitalization (that is, the value that investors assign to a company: its share price multiplied by the number of shares outstanding). Borrowing on a term popular 40 years ago, Bernstein called the 50 largest companies the “Nifty 50.” He called the 450 remaining companies the “Not-So-Nifty 450.”

Despite the disparaging moniker, Bernstein, starting in 1999, favored the 450 over the 50. At the time, he writes today, the Nifty 50 stocks were “dominated by technology shares and lower-quality issues” and “sold at exorbitant valuations.” But now, the tables have turned. Last month, he announced to clients “the Return of the Nifty 50.”

The reason is simple: The composition of the two groups has changed drastically. Companies that used to be among the top 50 by market cap – many of them tech firms like Sun Microsystems Inc. (SUNW) and EMC Corp. (EMC) – have suffered huge price declines and have skidded into the bottom 450. Of the “two universes,” Bernstein concludes, “the Nifty 50 is now the higher-quality one, the higher-yielding one and the cheaper one.”

If you are looking for inexpensive, classy stocks that may turn a small fortune into a larger one, you would do very well by simply confining your search to the Nifty 50 – to companies such as Johnson & Johnson (JNJ), which now ranks eighth in market cap; Coca-Cola Co. (KO), which ranks 10th; or American International Group Inc. (AIG), the insurance giant, at No. 7.

Of course, the term “Nifty 50” itself may not inspire confidence. In the 1960s and ’70s, it denoted something different: a group of 50 companies favored by institutional investors as “one decision” stocks – ones that could be bought at any price because they performed with such consistency.

While over time these stocks, as a whole, did indeed produce good returns, many of them flopped. In 1963, for example, Polaroid Corp. began making instant color film, and the next year it split its stock 4-for-1. By 1972 it was trading at a price-to-earnings ratio of 95. That turned out to be the peak.

Polaroid (PRDCQ) slid for the next 30 years before filing for protection under Chapter 11 of the bankruptcy act. It now trades for a penny a share.

Nifty 50 stocks in the 1970s – including Avon Products Inc. (AVP), International Flavors & Fragrances Inc. (IFF) and McDonald’s Corp. (MCD) – were characterized by price-to-earnings (P/E) ratios of 60 or higher. When the market tumbled in ’73 and ’74, these stocks had a long way to fall – and they landed with an ugly thud.

The point is that price counts as much as quality – and the main attraction of the Nifty 50 today is that it is a group of excellent companies that are inexpensive by any historical standard. One popular way to measure valuation is to look at dividend yields. Forty-three of the 50 pay dividends, and average yield is 1.9 percent – that’s more than double the yield of the Nifty 50 list in March 2000 (0.9 percent), and it’s even more attractive than it was then since Treasury bond yields have dropped sharply in the last two years. The average Nifty 50 stock today pays a dividend that’s greater than the interest rate on a two-year, AA-rated corporate bond. Now that’s cheap.

Among the stocks on the list with attractive yields are Citigroup Inc. (C) at 2.5 percent; ChevronTexaco Corp. (CVX) at 4 percent; 3M Co. (MMM) at 2.1 percent; and Wyeth (WYE) at 2.7 percent.

As for P/E ratios: In 2000, the Nifty 50 traded at triple the P/E of the Not-So-Nifty 450. Today, the gap has closed, and, says Bernstein, “we may be approaching the opposite extreme. Based on current-year earnings estimates, the Nifty 50 is the cheapest relative to the Not-So-Nifty 450 in 16 years.”

Home Depot Inc. (HD), for instance, trades at a P/E of just 16; Bank One Corp. (ONE), 13; General Electric Co. (GE), 15; and Philip Morris Cos. (MO), just 8.

Quality is more difficult to assess, but there is little doubt that the 50 largest U.S. stocks have improved in their soundness and that the 50 now far surpass the 450. Standard & Poor’s gives letter ratings to companies based on the consistency of their earnings and dividends over the preceding 10 years.

Currently, 82 percent of the Nifty 50 receive a rating of at least A-minus while just 51 percent of the Not-So-Nifty 450 meet that quality standard.

Twelve Nifty 50 stocks receive the top S&P rating, A-plus: General Electric (GE), Wal-Mart, Pfizer Inc. (PFE), AIG, Johnson & Johnson, Merck & Co., Philip Morris, Fannie Mae (FNM), Home Depot, Anheuser-Busch Cos. (BUD), Freddie Mac (FRE) and Fifth Third Bancorp (FITB).

Not only is the Nifty 50 a great place to go looking for individual stocks, it also makes a fine portfolio by itself. Unlike the 50 largest stocks a couple of years ago, this list is well diversified. For example, during 1999 and 2000, there were 17 high-tech stocks on the Nifty 50; today, there are just eight. (The current 16 percent tech composition is precisely the same as for the S&P 500 as a whole, and it roughly reflects the importance of tech to the overall economy.) And, by the way, all eight tech stocks appear to be solid citizens: Microsoft, Intel, International Business Machines Corp. (IBM), Cisco Systems Inc. (CSCO), Dell Computer Corp. (DELL), Oracle Corp. (ORCL), Hewlett-Packard Co. (HPQ) and Texas Instruments Inc. (TXN).

The Nifty 50 also includes 13 financials, 10 health care companies and nine consumer-products or retail firms. It’s a little light on energy (just two stocks) and industrials (just three), but it makes a nice portfolio.

Still, simply buying the biggest of the big (the cutoff point for inclusion in the Nifty 50 is a market cap of about $41 billion) is not a sophisticated investment strategy. You need to examine the companies before you buy them.

In the end, the most valuable use of the Nifty 50 is as a resource guide to trading up – to swapping mediocre stocks for the very best. During a bear market, there is simply no excuse for holding a portfolio of companies that are less than what Warren E. Buffett, chairman of Berkshire Hathaway Inc. (BRK), calls “wonderful.” Yes, the prices of companies like Cisco and Merck can go lower. And yes, you have to have a long-term perspective and strong discipline. But if you are going to be a stock investor at all, you should be a partner in the finest businesses in the world. Now’s your chance.

Ambassador Glassman has had a long career in media. He was host of three weekly public-affairs programs, editor-in-chief and co-owner of Roll Call, the congressional newspaper, and publisher of the Atlantic Monthly and the New Republic. For 11 years, he was both an investment and op-ed columnist for the Washington Post.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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