Investors who buy a portfolio of high-octane stocks at stratospheric prices and hang on to them are richly rewarded in the long run.
That's the conclusion of Jeremy J. Seigel, a professor of finance at the University of Pennsylvania's Wharton School, and author of the best-selling business book "Stocks for the Long Run."
Mr. Seigel bases his conclusion on an examination of the 25-year returns of the 50 large high-flying stocks known in the 1970-'72 bull market as the "Nifty 50."
In a study published in the Journal of Portfolio Management, Mr. Seigel found the group handily outperformed the market between December 1970 and May 1995. Based on an equally-weighted portfolio - where each stock had a 2% share and the portfolio was rebalanced monthly - the 50 stocks logged returns 37% higher than a composite market index, comparable with the Wilshire 5000, Mr. Seigel found. Thus, $1 split equally among the Nifty 50 in December 1970 would have grown into $20.33 by May 1995, compared with $14.82 for $1 invested in the composite market index.
While investors who held the entire portfolio all through have profited handsomely, Mr. Seigel believes his findings also apply to investors who pick a similar portfolio of richly priced growth stocks today - with consistent earnings growth upward of 15% to 20% and uninterrupted dividend increases.
Companies that fit the profile today include Campbell Soup Co., American Home Products, General Electric Co. and Kellogg Co., Mr. Seigel says, as well as a number of companies on the original list. Those include Coca-Cola Co., Gillette Co., International Flavors and Fragrances Inc., Johnson & Johnson, McDonald's Corp., Merck & Co. Inc. and Procter & Gamble Co.
Mr. Seigel believes growth stocks still have further upside potential, even though today's top performers are trading well below the huge multiples the Nifty 50 traded at then. (The Nifty 50 traded at an average of 41.9 times earnings at the market's peak in December 1972, vs. 19.3 for the composite market index.)
"People are very conservative in putting a premium on growth stocks and in many cases they will prove to be too conservative," Mr. Seigel said. "Growth stocks very well could be worth 30 or 40 times earnings, even higher."
His results come at a time when money managers, bombarded with conflicting signals about the nation's economic outlook, are fleeing to solid, predictable large-capitalization growth stocks like consumer non-durables.
Mr. Seigel's conclusion also flies in the face of conventional wisdom and ignores the notion popularized by Benjamin Graham and David Dodd, the fathers of modern security analysis, that investors who buy stocks at more than about 20 times average earnings are likely to lose their shirts in the long run.
"It's a real contrarian paper because most people, if you were to poll them, would say that the Nifty 50 was a disaster," said Tim Loughran, a professor of finance at the University of Iowa, Iowa City. "But these are the big winners over all these decades."
The original group of stocks Mr. Seigel studied consisted of such household names as Philip Morris Cos. Inc., McDonald's, Coca-Cola and Gillette that traded at steep prices compared with their earnings. But while the Nifty 50 were the darlings of Wall Street for a while, they fell out of favor after the market fall of 1973. And, despite their stellar performance, they remained out of favor by investors for years after the 1973-'74 bear market.
Mr. Seigel's study shows that investors who had not deserted these stocks would have earned returns of 13.13% a year through May 1995, for an equally weighted portfolio, or 12.41% for a "frozen" portfolio of the original 50 stocks, compared with 11.67% a year for the composite market index.
Topping the performance charts is Philip Morris, which racked up 21.03% a year between December 1970 and May 1995, followed by McDonald's, which showed a robust 18.35% performance, and PepsiCo Inc., which turned in 17.12%. Others at the top include Coca-Cola, Walt Disney Co. and Merck.
Of course the Nifty 50 was not without duds. An investor in MGIC Investment Corp., a mortgage investment company, would have ended up with only a third of the original investment, including reinvested dividends. And several others logged returns even lower than Treasury bills over the period.
And while Mr. Seigel found that a frequently rebalanced equally-weighted portfolio of the 50 stocks did better over the long haul than a portfolio that was not rebalanced, he now suggests it might be better not to rebalance and let the winners dominate over the long run. In particular, Mr. Seigel noted transaction costs of frequent rebalancing such a portfolio might eat into returns.
Peter del Greco, a growth stock manager at Freedom Capital Management Corp., Boston, independently concluded that with the economy's moderate growth at this late stage in the economic cycle, multiples on growth stocks could expand 10% to 20% if inflation and interest rates stay low.
Stocks such as Microsoft Corp. - one of the most expensive growth issues today, trading at 30 times projected 1996 earnings - or Oracle Systems Corp., trading at a similar level, could even rise further, Mr. del Greco said.
Even though Mr. del Greco's portfolio includes such Nifty 50 stocks as Philip Morris and Eli Lilly & Co., he said he doesn't buy into Mr. Seigel's theory of ignoring valuations even if the environment is ripe for growth stock multiples to expand.
Other active managers also take issue with Mr. Seigel's hypothesis, saying it ignores reality.
"It's great to do these academic studies, but as an academic you don't have a client breathing down your neck every quarter," said Gurudutt Baliga, a portfolio manager at IDS Advisory Group in Minneapolis. "The problem is you are on the firing line, and the sector or the stock has to perform during the quarter; otherwise you can say goodbye to your style."
Richard Hughes, president of Rittenhouse Financial Services Inc., Radnor, Pa., agreed.
"We are not growth at any price. We cannot be oblivious to price because our timeframe is not a 30-year timeframe. Our clients' objectives and goals are much shorter so we have to focus on a much shorter timeframe."