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Stock Strategist

After the Party's Over, It's Time to Invest

Use history as your guide to profit from today's great growth companies.

After a bubble bursts, investors can sometimes behave irrationally and ignore some very attractive bargains for fear of losing their shirts again. As value investors, we like to think that we have both the temperament and good judgment to recognize and profit from these opportunities.

Cinderella Story
One of my favorite quotes from last May's  Berkshire Hathaway (BRK.B) annual meeting was when a shareholder asked Warren Buffett and his partner Charlie Munger about the potential for a bubble in the commodity markets. Buffett used Cinderella to illustrate his viewpoint. While he applied this analogy to commodities and the price of copper, I think it applies to a speculative bubble in any asset class.

"It's like Cinderella at the ball," Buffett said. "At the start of the party, the punch is flowing and everything's going well, but you know that at midnight everything's going to turn back to pumpkins and mice. But you look around and say, 'one more dance,' and so does everyone else. Everyone thinks they'll get out at midnight. ... And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice."

What Buffett didn't say, but I think he would agree is the next logical conclusion to this statement, is that while there are sure to be many rotten pumpkins and dismembered mice lying around amid the midnight metamorphosis, patient investors can also uncover some screaming bargains.

The Nifty Fifty
I was recently thumbing through Jeremy Siegel's Stocks for the Long Run, wherein he details the rise and fall of a group of stocks from the 1970s dubbed the Nifty Fifty. The Nifty Fifty were a group of growth stocks that investors thought could do no wrong, and investors thus bid up these 50 stocks to excessively high valuations before they eventually collapsed in the 1973-1974 bear market. While Siegel contends that an investor who had purchased shares in some of the so-called Nifty Fifty companies at the height of the 1972 bull market could have still almost matched the return on the S&P 500 from December 1972 to November 2001, for me, at least, the opportunity cost of doing so would have been far too great.

As a value investor, I'd much rather have waited for investors to rush for the door selling these stocks before starting to consider any of them as potential investments. Even though the heightened selling was an indicator of extremely negative public sentiment toward many of these companies, many of the underlying businesses remained firmly intact and were actually set to post tremendous growth for years to come. In fact, Siegel acknowledges that after the crash, many of the Nifty Fifty remained undervalued for years, despite the businesses of  Coca-Cola (KO),  PepsiCo (PEP), and  General Electric (GE) to name a few continuing to grow both earnings and intrinsic value. On page 160 of Stocks for the Long Run, Siegel says "the prevailing cautious attitude toward growth sent the Nifty Fifty stocks to dramatically undervalued levels throughout the 1980s and the early 1990s."

In this sense, Wall Street irrationally penalized these truly fantastic growth companies because investors had been burned so badly by the lofty prices they had paid in the early 1970s. Had astute investors, in Buffett's words, "been greedy when others were fearful" the returns they could have garnered on these stocks would have handily outpaced those of the S&P 500.

The Internet Bubble
As I'm sure you're well aware, a similar episode to the 1970s Nifty Fifty occurred more recently with the boom and bust of technology stocks. As Siegel details on page 149 of Stocks for the Long Run, there were really two technology bubbles. "After the pure Internet stocks [think dot-com] peaked in 1999, investor interest shifted to what was known as the 'backbone' of the Internet�.networking and storage companies, software manufacturers, and firms pioneering wireless communications."

However, in March 2000, when the technology-laden Nasdaq Market Index reached its peak at more than 5,000, both groups of stocks suddenly crashed and the Nasdaq bottomed out at under 1,200 by September 2002. This bust not only took many of the unprofitable dot-com companies with it, but also many companies with solid business models and very favorable long-term growth prospects. The problem was that prior to the bubble's bursting, investors obviously paid far too much to try to participate in this growth. After the collapse--when some of these growth companies seemed more reasonably priced--investors were so badly burned, that they have shunned these stocks for the last few years. However, if we use the Nifty Fifty as our guide, it smells like there still might be value to be had in the wake of this fallout.

Today's Market
So then, how can we identify those stocks to profit from this time around? Well, in order to get a feeling for which stocks are being shunned by investors, I looked at the five-year performance of some of Morningstar's stock indexes. For example, as of Oct. 12, the five-year total return of Morningstar's Large Cap Growth Index was negative 0.04% per year. Over the same period, many of Morningstar's value and small-cap indexes have had five-year total returns that have reached double-digits annually. While I'd never buy a stock or group of stocks based solely on index returns, I do think that this bifurcated performance indicates an area warranting further research.

 Five-Year Performance of Selected Morningstar Indexes
Index Five-Year Return*
Morningstar Small Value TR 18.03
Morningstar Mid Value TR 15.45
Morningstar Large Value TR 9.85
Morningstar Mid Growth TR 8.48
Morningstar Small Growth TR 8.25
Morningstar Large Growth TR -0.04
* As of 10-12-06

Next, I've compared the composition of the above lagging indexes to the Morningstar Ratings for stocks as of Oct. 12. My research indicates that our analysts believe that  Dell ,  Microsoft (MSFT),  Yahoo ,  EMC Corporation , and  Broadcom  to name a few, continue to have great growth prospects, while their valuations have remained relatively stagnant over the last few years. Not surprisingly, each of these companies also boasts a 5-star Morningstar Rating.

  Good Growth Prospects at a 5-Star Price
Stock Morningstar
Fair Value Estimate Price/
Fair Value
Dell  $39 61%
Broadcom  $47 63%
Yahoo  $37 66%
EMC  $19 67%
Microsoft (MSFT) $34 83%
*As of 10-12-06

Even though Buffett would likely admit that these companies were outside of his circle of competence, they don't have to be out of yours. By using Morningstar's research to identify those great growth companies that the market continues to treat like "pumpkins and mice," I think astute investors who don't mind going against the crowd presently have the opportunity to make investments that will compound for years to come.

Justin Fuller has a position in the following securities mentioned above: DELL, MSFT, GE. Find out about Morningstar’s editorial policies.