The Rational Investor #047: Trees Don’t Grow to the Sky
Happy Saturday to you,
Welcome to the 47th edition of The Rational Investor Newsletter.
Today’s quote comes from the book Against the Gods: The Remarkable Story of Risk by Peter Bernstein. The book itself is a historical look into risk in all its forms. Candidly, I found it a little tough to get into, but some of the insights are incredible. One such example is today’s quote that offers a look back into the Nifty-Fifty era of investing. As you’ll see, this draws an interesting comparison to today’s stock market, which I’ll talk briefly about after the quote.
Onto the main event…
Here’s Peter Bernstein on Trees Don’t Grow to the Sky [Italics are that of the author; Bold emphasis is mine]:
“Consider a great growth company whose prospects are so brilliant that they seem to extend into infinity. Even under the absurd assumption that we could make an accurate forecast of a company’s earnings into infinity—we are lucky if we can make an accurate forecast of next quarter’s earnings—what is a share of stock in that company worth? An infinite amount?
There have been moments when real, live, hands-on professional investors have entertained dreams as wild as that—moments when the laws of probability are forgotten.
In the late 1960s and early 1970s, major institutional portfolio managers became so enamored with the idea of growth in general, and with the so-called ‘Nifty-Fifty’ growth stocks in particular, that they were willing to pay any price at all for the privilege of owning shares in companies like Xerox, Coca-Cola, IBM, and Polaroid.
These investment managers defined the risk in the Nifty-Fifty, not as the risk of overpaying, but as the risk of not owning them: the growth prospects seemed so certain that the future level of earnings and dividends would, in God’s good time, always justify whatever price they paid.
They considered the risk of paying too much to be minuscule with the risk of buying shares, even at a low price, in companies like Union Carbide or General Motors, whose fortunes were uncertain because of their exposure to business cycles and competition.
This view reached such an extreme point that investors ended up by placing the same total market value on small companies like International Flavors and Fragrances, with sales of only $138 million, as they placed on a less glamorous business like U.S. Steel, with sales of $5 billion.
In December 1972, Polaroid was selling for 96 times its 1972 earnings, McDonald’s was selling for 80 times, and IFF was selling for 73 times; the S&P 500 stocks were selling at an average of 19 times. The dividend yields on the Nifty-Fifty averaged less than half the average yield on the 500 stocks in the S&P Index.
The proof of this particular pudding was surely in the eating, and a bitter mouthful it was. The dazzling prospect of earnings rising up to the sky turned out to be a lot less than an infinite amount.”
I hope the parallels to today’s market—and frankly, the market of the last few years or so—are clear. We live in a world today where the great technology companies—which are undoubtedly incredible companies—can do no wrong.
While the valuations for most of these companies are not quite at the nosebleed levels of the Nifty-Fifty, they are significantly higher than the rest of the market. Whether that turns out to be an issue in the long term remains to be seen, but the goal of learning from history is to bring awareness to potential issues such as these to ensure that we don’t follow in the foolish footsteps of the investors who have come before us.
Luckily, at least as far as index investors are concerned, our job is simply to remain committed to owning the market at all times—thus guaranteeing our proportionate share of growth in global wealth—and then, not thinking much more about it than that. In the end, I trust that things will work themselves out for the best, just as they always have.
Thanks for reading. I’ll be back next week with more timeless wisdom from great investors.
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