Growth stocks were in vogue by the end of 1972. The five most popular companies had a market cap of $100 billion on earnings of $2.2 billion.
$100 billion is nothing by today’s standards, but those five companies — IBM, Minnesota Mining (3M), American Home Products, Xerox, and Eastman Kodak — accounted for 15% of the total market cap of every company listed on the NYSE. They had an average P/E of around 40. The general view was their growth made them “safe.”
Therein lies a problem. Equating high multiples with “growth” is a common mistake made by investors. But making the leap from “growth” to safety compounds the error.
The skill is in separating growing companies from high multiple stocks that are rising in price. Because one meets certain characteristics that drive earnings growth over time. The other has only to do with price action.
Peter Bernstein laid out some of those growth characteristics in a 1956 article. It included basic fundamentals like consistently rising earnings, dividends, unit sales growth, and a high return on equity and/or assets. A high multiple and rising stock price was not on the list.
The popularity of those five stocks in 1972 was enough for Peter Bernstein to ask an important question:
The crucial question suggested by the prestige that the market attaches to growth is: Can growth continue to pay off in superior results when it already enjoys such extraordinary and visible popularity? If, as experience tells us, great investment opportunities exist only for those who recognize them early and when they are thus less than fully exploited, the growth stocks at “popular” levels may offer greatly reduced opportunities for high rates of return. If, on the other hand, economic, political, and social fundamentals suggest that these are the only companies in which it is safe to invest in this environment, then investment money will continue to flow toward them in quantity.
Then he looked back at companies mentioned in his 1956 article along with other growth stocks from 1955 to 1972 to try and answer it. His conclusions on the era might be helpful for investors enticed into buying similarly high multiple “growth” stocks today.
- A high P/E multiple does not equate to a good company or great stock performance over the long run.
- A low P/E multiple does not protect from declines in stock price either.
- There’s a clear correlation between earnings and stock price. Rising earnings leads to a higher stock price. The best stock price performers were also the best earnings performers. The worst stock performers were the worst earnings performers too. The biggest losers had the combination of a high starting P/E and poor earnings performance. The biggest winners had only slightly above average starting P/Es and excellent earnings performance.
- Only three companies that started with a high P/E also had great stock performance over the period. In other words, a rare few companies achieved the earnings performance needed to exceed already lofty expectations priced into the stock.
- Return on book value was, generally, a solid guide for stock and earnings performance. A high return on book typically had higher earnings and stock performance while a low return on book had the worst earnings and stock performance.
- “Past corporate successes are only frail guides to future good fortune. Neither the corporate executive nor the investment manager can allow himself to be lulled into the belief that any company, regardless of its record of achievement, must necessarily provide satisfactory rates of growth. All stocks are “two-decision” stocks; and no such thing as a “one-decision” stock exists.”
- Valuation multiples reflect what investors expect to happen, not what will happen. Investors pay a high multiple because they have high expectations. It tells us nothing about future earnings growth or risk.
- The periods where growth outperformed the market were also periods where investors were skeptical about continuing business and economic growth. Money moved toward two types of companies: those viewed to be “safe” or least impacted by economic problems and those with exciting new products/services and no past history in an economic downturn.
- The question to ask is: How sustainable is a company’s growth rate and does it justify its current valuation?
- “Managements, products, competitors, company size, and the direction of the economy itself are constantly changing. Today’s beauty can well turn out to be tomorrow’s hag.”
The key lies in earnings. High expectations may inflate stock prices but it’s not enough to maintain performance forever. Earnings growth matters in the long run.
This was a costly lesson for investors in 1972 that bought high multiple “growth” stocks that were rising in price. Little did they know the bull market was near its end.
The 1973 – 1974 market crash was enough to reset expectations. High multiple stocks that lacked earnings growth were hit hardest. Buying “growth” stocks without earnings growth is a recipe for disaster.
Advice to Managers: Watch Earnings, Not the Ticker Tape
Peter Bernstein’s Checklist for “Growth Companies”
Phil Fisher: The Art of Holding On