How many of you have ever heard about the catastrophic performance of blue-chip stocks during the 1973-1974 period (the so-called "Nifty Fifty Days") touted as evidence that a blue-chip stock or dividend growth investing strategy can fail? As we dig into the data, I want to share with you one of the most important truths about dividend growth investing with blue-chip stocks: it is usually not the performance of the blue-chip stock that gets you into trouble. Rather, it is the irrationally high valuations (read: other people paying too much for dividend stocks) that can cause periods of terrible total return performance for such an investor.
As Roxann Klugman writes in her book "The Dividend Growth Investment Strategy," the valuations of blue-chip stocks dubbed "The Nifty Fifty" became excessively overvalued in relation to the rest of the stocks in the market at the end of 1972. She writes:
"At that time (referring to the year 1972), these blue-chip stocks ran very high P/E's (the S&P 500 average was 18.9; the Nifty Fifty P/E averaged 41.9), historically very high for the market. In 1973-1974, a bear market hit that caused share prices to hemorrhage for nearly two years."
Take a minute and think about that. The Nifty Fifty had a P/E average of 41.9. That's an earnings yield of 2.38%. That's pitiful. I know of investors on this website that insist upon higher starting dividend yields than that! If you have the slightest respect for the work of Benjamin Graham, you wouldn't even consider buying a stock once its P/E ratio surpassed 20x earnings, a price that will give you a much higher 5% starting earnings yield on your investment. The reason why Benjamin Graham insisted upon that figure is because the kind of growth needed to justify an investment over 20x earnings must be so high that it would be speculative by its very nature. It's hard to get rich when you buy a mature business from a starting earnings yield of only 2.38%. That should be the take-home lesson from the Nifty Fifty meltdown during the 1973-1974 bear market.
The problem was not that the business performance of blue-chip stocks lagged, but that the valuation of blue-chip dividend stocks at this time was completely detached from reality. I'll give you a couple of examples from Ms. Klugman's work. She pointed out that in 1972 Gillette (now part of Procter & Gamble (NYSE:PG)) was trading at 24x earnings. Coca-Cola (NYSE:KO) was trading at 47x earnings. Pfizer (NYSE:PFE) was trading at 28x earnings. Merck (NYSE:MRK) was trading at 43x earnings. General Electric (NYSE:GE) was trading at 23x earnings. Johnson & Johnson (NYSE:JNJ) was trading at 57x earnings. From a value investing perspective, these were ridiculous times. How the heck can you expect to generate excellent returns, be they income or total returns, when you pay 57x earnings for a large-cap healthcare company?
Of course, the businesses themselves generally performed quite well from the early 1970s to the present. Klugman does a fantastic job of pointing out the excellent dividend growth that these firms were able generate as they continued to generate gushers of profit for owners through the 1970s, 1980s, 1990s and 2000s. Let's take a look at the figures for long-term dividend growth. General Electric continued to raise dividends at an average rate of 11% annually for decades. Merck, 16%. Coca-Cola, 11%. Gillette, 13%. And for Johnson & Johnson and Pfizer, the long-term figures were 13% and 12% respectively. It is not the fault of any of these companies that they turned out to be bad investments. It is the fault of the investor that chose to pay 41.9x earnings for these stocks in 1972 that caused a blue-chip strategy to appear to fail. What income investor would initiate positions in stocks yielding one percent? It was the terribly high valuations that doomed investors.
This is why I don't take claims comparing blue-chip stocks to the dotcom bust, the financial crisis, or the real estate crash seriously. The failures were completely different. The dotcom bubble caused a crash because people were paying 100x earnings for companies that couldn't sustain profits, and were destined for bankruptcy. The financial crisis caused problems because the profits at most banks evaporated all at once. Similar story with real estate. But the takeaway message is this: the bubbles caused investors a whole lot of pain because the businesses failed. When you're dealing with Coca-Cola, Pepsi (NYSE:PEP) and Procter & Gamble, the primary concern is not that those companies are going to go bankrupt. The primary concern should be that you might overpay too much for the stocks. That's what the lesson from the 1973-1974 Nifty Fifty crash should be.
By the way, we are nowhere near that now. Most of the blue-chips mentioned above are trading between 18-23x earnings today. That probably indicates full valuation, and possibly mild overvaluation, but it is nowhere near the excessive valuations that wreaked havoc on the markets in 1973-1974. People were paying 41.9x earnings for blue-chip stocks then. Literally, you were getting ½ the profit and ½ the dividends for every dollar deployed in 1972 compared to 2013. If you convert to blue-chip investing, you absolutely have to monitor your companies. That will always remain the case. But if you own a diversified basket of blue-chip stocks, it is not business failure that will be your primary risk. That's not what will doom your strategy. It's the valuation you have to watch out for. That's what the worst bear market of the 1970s taught us.