Back in 1967 a man calling himself Adam Smith wrote a wonderful book called The Money Game. Smith — actually a professional investor called George Goodman writing under a pseudonym — devotes one chapter to what he called “The Cult of Performance”. In it, he describes the shift that took place in fund management in the 1960s.
Before then, portfolio management was not an “Instrument of Personality”. Funds were instead run by a “Prudent Man” — the kind who “died with an estate that won the admiration of the lawyers for its order and efficiency”.
His portfolio had around 200 stocks in it — the 200 biggest companies in the US. These made up two-thirds of the assets — bonds made up the rest.
This was straightforward, formulaic stuff. If our man was to make a radical move, he might “reduce Steels from 3.3 per cent to 2.9 per cent and buy a little more Telephone.” (Smith was an enthusiastic user of capital letters.)
Then something changed. Where there hadn’t been much money, there was suddenly a great deal of money. In 1946, $1.3bn was invested in mutual funds. By 1967 that number was $37bn (plus another $150bn in pension funds). Seven times as many Americans held shares by the end of the 1960s as had during the height of the 1929 bubble.
At the same time, a new group of managers arrived. These were “tigers” not remotely scarred by the horrors of 1929. They saw that the best capital gains weren’t coming from America’s big old companies, but newer growth companies. Think Xerox, Disney, Polaroid, Eastman-Kodak and IBM. The stage was set for The Cult of Performance.
Fund salesmen found people weren’t interested in “nice balanced diversified funds” any more. They wanted the funds that had gone up the most — and that they figured would continue to go up the most. Initially that mostly meant the Fidelity Trend Fund (up 56 per cent in 1965) and the Dreyfus Fund (the first to run a real retail advertising campaign — featuring a real lion emerging from a subway station on Wall Street).
But soon the method was jammed with Instruments of Personality — Fidelity’s Gerry Tsai raised $274mn in a day for his Manhattan performance fund against an original target of $25mn — and everyone was getting into the growth game.
Even the head of the supposedly conservative Ford Foundation was muttering about caution costing more than risk taking. Look at how the performance managers are doing, he said, and surely funds such as his should be changing direction: “The true test of performance in the handling of money is the record of achievement not the opinion of the respectable.” I imagine that in later years he filed this under things he wished he had never said in public.
“It may all go too far,” said Smith in 1967. The respectable “may be right”. It did and he was.
The performance stocks, which became known as the Nifty Fifty, went nuts, with price/earnings ratios hitting 50x times plus across the board. Polaroid was the winner on 94.8 times at its peak.
Then oil prices, inflation and interest rates all rose fast, the Bretton Woods system came to an end and it all came tumbling down. By 1974 Polaroid was down 91 per cent. The Fidelity Trend Fund fell 23 per cent in 1973 and 31 per cent in 1974.
This will all sound familiar. Replace Fidelity with Baillie Gifford, performance with growth and Polaroid with Netflix and you will see the story is very much the same. This brings me neatly to what Ed Yardeni of Yardeni Research calls the MegaCap-8: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Netflix, Nvidia and Tesla.
Until very recently this lot were treated just as the performance stocks were in the 1960s. They were where the growth was. You bought them and you held them forever. Price was irrelevant.
In a low growth world you didn’t need prudent men, or those looking for what we used to call GARP (growth at a reasonable price). You needed those who would buy growth at any price (GAAP).
Tesla peaked on a price/earnings ratio of 163 in August 2020, says Yardeni. Amazon hit 85x and Netflix 66x. It went too far. Then oil prices, inflation and interest rates began to rise. And here we are.
Collectively, the MegaCap-8 lost 6.1 per cent on Tuesday. They are now down 27 per cent year to date (the S&P 500 is down 17 per cent). The only one that has outperformed the S&P 500 (a low bar) is Apple (down 13.4 per cent). The p/e ratios look slightly less mad: Tesla is on only (!) 53 times and Nvidia on 32. Netflix has made its way down to 20x due to a 60 per cent fall in its share price so far this year.
The lesson here isn’t exactly a new one but it is worth keeping the Nifty Fifty and the MegaCap-8 in mind as you and your portfolio navigate the next few years. It is this: price matters.
We have just been through a period in which I have been constantly told that we must pay up and up for growth and for quality — quality being shorthand for businesses with predictable earnings streams. But the past few months have made it clear that this only works if you have total clarity over the unfolding of the future.
If you could have known for sure when you paid 80 times for a stock that interest rates were to stay low forever, that its earnings would be just as you predicted and its growth all but permanent, it might have made sense.
With the knowledge that the future is generally unguessable and that even great companies can be bad investments if bought in a bubble, might you not be better just buying the cheapest cash flows you can find? Do this, say analysts at Orbis, and with each passing year “your need for a crystal ball dissipates”.
Let me end with some good news for those of you still determined to hold the Megas (just one-fifth of investors questioned by exchange-traded product provider GraniteShares say they have sold or cut their US tech investments).
In the year before their stunning pandemic melt-up, the eight had a collective forward p/e of around 24 times. It isn’t much higher than that now — just over 25 on Yardeni’s numbers — so things are looking a little more normal, if still quite expensive in historical terms.
Two weeks ago Orbis, mainly a value investor, noted that on current valuations, with a p/e of around 20 times, Alphabet can now be considered a value stock (it is cheaper than the S&P 500 as a whole) or a growth stock — or perhaps even just a big US company offering a little GARP for the Prudent Man.
Merryn Somerset Webb is editor-in-chief of Money Week. The views expressed are personal. merryn@ft.com
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