Inside today’s Daily Journal…

I promised yesterday that I would tell you something most people don’t know about the Nifty Fifty.

But let’s start with what everyone “knows” about that incredible mania in the stock market.

Buying the Nifty Fifty – the market’s best and most expensive stocks in 1972 – was one of the worst possible financial decisions you could have made in the last 100 years. Your portfolio would have gone down 20% in 1973. And then another 38% in 1974. And the recovery did not come. The group’s price-to-earnings (P/E) ratios (that’s how much their shares cost expressed as a multiple of their earnings) declined from over 50x earnings to under 10x earnings by the early 1980s.

That’s the story I’m sure you’ve heard a dozen times before: the Nifty Fifty was a disaster for investors. But it’s not true. In fact, even if you bought those stocks at the absolute worst moment, right at their peak in December 1972, you still did pretty well, over the long term.

If you bought all those stocks at their peak, in December 1972, and you held for 25 years, you ended up compounding your capital at about 12.5% a year, which is more or less in line with the market’s average result. (See Financial Analysts Journal, “Valuing Growth Stocks: Revisiting The Nifty Fifty” published in 1998.)

How’s that possible? It’s simple. Inside those 50 stocks were some of the highest-quality businesses that have ever existed, companies that continued to compound capital at very high rates. Owning just a few of these stocks, for the long term, will make up for a lot of financial “sins.”

As you know, returns in the stock market have an extreme “power law” distribution, where only a few stocks earn virtually all the returns. In the Nifty Fifty, virtually all the returns accrued from 10 companies: Philip Morris International (PM), Merck (MRK), Coca-Cola (KO), Bristol-Myers Squibb (BMY), Pfizer (PFE), GE (GE), Schering, PepsiCo (PEP), Eli Lilly (LLY), and McDonald’s (MCD). The winners were all branded consumer products companies and pharma stocks. Why? Outstanding economics – very capital efficient businesses – and a moat against competition.

The other factor, and the one I want you to focus on today, was price.

The companies that performed the best for investors over the next 25 years were not trading at absurd multiples. The two best performers (Philip Morris: 18.8% annually, Pfizer: 18.1% annually) were trading around 25x earnings at their 1972 peaks. The disasters – Polaroid at 94.8x, MGIC Investment (MTG) at 68.5x, International Flavors & Fragrances (IFF) at 69.1x, Baxter International (BAX) at 71.4x – were the names with the absurd multiples in 1972.

Note: there was one exception – McDonald’s returned 12.1% annualized from December 1972 through August 1998 despite reaching 71.0x P/E in 1972. McDonald’s is probably the best business that’s been created in the last 80 years: even buying it at 70x earnings didn’t wreck future returns!

Throughout my career, I’ve consistently tried to explain that owning high-quality businesses is, hands down, the best way to protect yourself from economic downturns. Great businesses beat gold. They beat real estate. They even beat timber. When I try to explain why, most folks look at me like I have four eyes. That’s because they don’t understand what’s so exceptional about a Philip Morris, or a Coke, or a McDonald’s to an average business. They’re just not the same things – at all.

And, of course, price matters.

The thing that destroyed the Nifty Fifty in 1973 and 1974 was not a collapse in their businesses. Coca-Cola kept selling soda. Merck kept selling drugs. McDonald’s kept selling hamburgers. What killed the stocks was the high share price compared to earnings.

The group went into the bear market at 50x earnings and came out at 8x or 9x. That implies an 80% decline in share prices, assuming earnings remained flat.

That’s what you must understand about today’s market.