Published:
June 8, 2009
In the late 1960s and early 1970s,
a small cadre of growth stocks seemingly defied gravity,
rallying almost without interruption despite wild gyrations in
the broader market indices.
This group of stocks came to be known as the "Nifty Fifty";
brokers pitched the group as single decision investments, names
investors could buy and hold forever. The list consisted largely
of American household names that most understood and felt
comfortable buying. Investors continued to buy these consistent
growth machines even as valuations approached stratospheric
levels.
As a vicious bear market kicked off in 1973, the Nifty Fifty
looked resilient, at least at first. Most of these bellwethers
continued to rally even as the broader market slumped. That
outperformance was taken as affirmation that the Nifty Fifty
were truly a special class of stocks that could generate
earnings growth regardless of market and economic conditions.
Of course, that theory was soon proven false. Eventually, the
worst recession in the U.S. since the 1930s eroded growth for
the Nifty Fifty just as surely as for smaller, less well-known
stocks. To make matters worse, the average price-to-earnings
(P/E) ratio for Nifty Fifty bellwethers such as Johnson and
Johnson (NYSE: JNJ) and McDonald's (NYSE: MCD) approached 100;
with valuations that high, these stocks were vulnerable to a
nasty sell-off at the first sign of slower growth.
Ultimately, the Nifty Fifty
collapsed, performing even worse than the S&P 500 in 1974. Some
of the most heavily owned names ultimately fell more than -75%
from their 1972/73 highs to their 1974 lows.
As it turns out, some of the Nifty Fifty had little real staying
power. Kmart, then known as S. S. Kresge, and Polaroid were
highfliers in the early 1970s. Both ultimately ended up
bankrupt.
But that certainly wasn't the case with all of the Nifty Fifty.
Many of these stocks were great companies with solid growth
prospects that were simply trading at excessive valuations in
1972 and early 1973. It wasn't the companies that were the
problem, but instead it was the prices investors were paying for
those firms.
In fact, some of the Nifty Fifty highfliers ultimately became
leaders in the powerful bull market of the 1980s and 1990s. From
1982 through 2000, for example, McDonald's and Disney (NYSE: DIS)
both returned +21% annualized against a +18% return for the S&P
over the same time period.
Market history has a habit of repeating. In the late 1990s and
early 2000, technology stocks became the market's darlings. Like
the Nifty Fifty three decades earlier, a long list of technology
firms soared to unprecedented valuation levels.
For example, networking giant Cisco Systems (Nasdaq: CSCO)
traded at 180 times earnings at its highs in the year 2000,
while online retailer Amazon.com's (Nasdaq: AMZN) multiple was
an even-loftier 325 times. As our chart shows, the S&P 500
technology sector as a whole traded with a price-to-earnings
ratio of more than 75 in 2000. To justify these nosebleed
heights, investors assumed the high tech New Economy would
enable growth unprecedented in U.S. history.
Of course, the New Economy ultimately looked a good deal more
like the Old Economy than many tech bulls cared to believe --
tech earnings growth ultimately came back to Earth in 2000 and
2001 and the sector collapsed. In the three years following the
tech-heavy Nasdaq's top in March 2000, the index lost nearly
three-quarters of its value.
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Some winners in the late 1990s
tech boom ultimately went bust. But just as with the Nifty Fifty
in the early 1970's, the majority of America's technology
bellwethers weren't bad companies. Instead, they were simply
trading at unsustainable valuation levels. Unfortunately, vivid
and unpleasant memories of the 2000 tech collapse have convinced
some investors to be permanently leery of the group.
But as this chart illustrates
(see chart), valuation levels for technology stocks have
fallen sharply from the exuberant heights of early 2000. The
group now trades in line with the broader market on a
price-to-earnings (P/E) basis -- the current P/E for the S&P
500 Tech sector stands at less than 16 times.
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More importantly, the group
has been handily outperforming the broader market. In the
first five months of 2009 alone, the S&P 500 Technology
Sector returned roughly +14% and the technology heavy Nasdaq
Composite delivered nearly +8% gains while the S&P 500
simply broke even.
This superior showing is justified by the tech sector's
fundamentals. Technology stocks are attractive for two basic
reasons: strong growth prospects and pristine balance sheets
(see chart below).
Consider that earnings for the tech-heavy Nasdaq Composite
are projected to grow nearly +17.0% this year compared to a
-7.2% decline for the S&P 500 as a whole. Even more
impressive, the five largest technology stocks in the S&P
500 are projected to see earnings growth of +4.8% on average
this fiscal year. That's a solid showing when you consider
the world remains mired in a nasty recession. It's even more
impressive when you consider the five largest non-tech
stocks in the S&P 500 are expected to see earnings shrink by
more than -15% on average this year.
And last year amid a
global credit crunch, investors refocused on corporate
balance sheets. Borrowing costs for even the most
creditworthy firms have increased markedly in recent
quarters. And companies with more shaky credit histories
have been totally unable to raise debt financing at any
cost.
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companies with heavy debt burdens can be expected to pay
much higher interest rates to obtain capital needed to
fund growth. And, in some cases, a heavy debt burden can
be fatal -- if a company can't meet the terms of its
debt covenants, bankruptcy is a very real risk.
With these points in
mind, companies with low debt burdens and large amounts
of cash on the balance sheet deserve to trade at a
significant valuation premium. These firms have no need
to sell bonds or take on credit lines to expand. Even
better, companies with solid cash positions have an
unparalleled opportunity to take advantage of depressed
market valuation levels to buy up competitors and
enhance their market positions. |
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On this basis, the technology
sector looks particularly attractive. As our chart indicates
(see chart), the average technology stock in the S&P 500 has
a debt-to-market capitalization ratio of just over +23%.
This is by far the lowest debt-to-cap ratio for any sector
in the S&P 500 and far lower than the S&P 500 average of
around 50 percent. In addition, around half of all tech
stocks in the S&P 500 have no net debt whatsoever.
For example,
Google (Nasdaq: GOOG, $440.28) has no debt and nearly $18
billion in cash. This strong financial position gives the
company the ability to make strategic acquisitions in an
environment where valuation levels for many internet companies
remain depressed.
My staff and I
believe Google is still a solid buy for growth-oriented
investors. It trades at 16 times projected earnings and has a
long-term growth rate of close to +19%. It's unusual to find a
market leader like GOOG trading at a discount to its long-term
growth rate. I believe that Google could trade at as much as 1.5
times its long term growth rate, which would equate to a P/E of
about 29 times. On that basis, the stock could trade as high as
$600, a +36% increase from its current price.
Good Investing!
Paul Tracy
Editor
StreetAuthority
Market Advisor
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Paul Tracy co-founded StreetAuthority.com and became the firm's
Chief Investment Strategist in 2001. He also co-founded TopStockAnalysts.com in
2006. Prior to that he spent several years as Managing Editor at a multi-million
dollar financial publishing firm with over 150,000 subscribers. In addition to
his role as managing editor and lead financial writer, he was also responsible
for equity research and managing a team of seasoned professional financial
writers, researchers and market commentators.
Paul's previous experience includes a position at Robert W. Baird & Co.'s
full-service brokerage operations as well as economic research work on a Money
and Banking project funded by the National Bureau of Economic Research. He has
also spent time doing outside consulting and research for the University of
Virginia, has appeared as a guest expert on several prominent financial radio
shows, and has been a featured speaker at various investment conferences across
the U.S.
Paul graduated with a B.S. in Finance and Management from the McIntire School
of Commerce at the University of Virginia.
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