Buy Great Companies and Hold Them. Really.

The headlines have been filled with the march of the Dow Jones Industrial Average to the high last reached in October 2007.  Yet, what the headlines don’t tell you is that if you factor in the effects of inflation the Dow actually does not reach new highs until 15, 651.80 over 1,000 points higher than the current level.  But even if you ignore the effects of inflation the question for the average investor is whether or not now is the time to commit new money to the market.  Yes, earnings have steadily grown as has the quality of the balance sheet since 2007.  And that means that valuations are much more attractive though the price level (as measured by the Dow) is approximately even.  But who wants to buy an asset when it has recently appreciated?  Shouldn’t I wait for a correction and buy stocks at cheaper prices?  Perhaps.  But, given the low returns in cash and the bond market and the relative attractiveness of stocks, it is conceivable the market will continue to rise in the short term; beyond the 2007 level into new highs.

Yet, short-term market levels are difficult, if not impossible, to forecast.  Look, instead, to the long-term. Incrementally buy the stocks of great companies and hold them.  Here’s why.

If you are a regular viewer of any of the financial news networks you may be hard put to find support for a buy and hold strategy.  This is not surprising since urgency and breaking news stories attract audience.  Buy and hold?  Not so much.

But for those of us who do not have the luxury of consulting an army of research analysts, accessing unlimited real time data or parking ourselves in front of the TV for the entire trading day, buying great companies and holding them for the long term is not only prudent, but a highly successful strategy.

Consider the results of Wharton School finance professor Jeremy Siegel’s research featured by Gene Epstein in this week’s Barron’s.  Siegel has compiled data on stock-market performance dating all the way back to the year 1871.  He examines the performance of stock returns in rolling five, ten, twenty and thirty-year periods.  His conclusion?  Over thirty years the median return for stocks is 9.22%.  For twenty years the median performance is 8.09%.  Despite the fact that the five and ten year periods can be negative (though the median return is 9.4% and 8.6% respectively) “all the 20- and 30-year periods have been positive.”

Since Siegel’s work includes stock-market performance, we can assume if we are buying excellent companies who are leaders in their business our returns should match, if not exceed the performance of the overall market.  The Dow stocks are a good place to start.  Look for the leaders.  Companies whose products you use.  Companies who demonstrate a history of growing dividends because managements and boards of directors tend to set their dividend as a portion of long-term, sustainable earnings power and that, after all, is one of the reasons we buy stocks–to own a share of future (growing) earnings.   Which, in turn, proportionally increases the value of our portfolio.  And that is the main reason we buy stocks.

Focus On Fallen Angels–Patience is the Key

In my previous post, I suggested that investors watch stocks they are interested in before plunging in. The title of the post was “Patience is Perspective.” In my thirty years of investing waiting has rarely cost me money. Trying to catch a falling knife has. Because I tend to buy “fallen-angel” growth stocks, waiting for the dust to settle is imperative. Fallen-angel’s present the greatest difficulty and the greatest potential for the value investor.

Fallen-angel growth stocks are well-managed, fast-growing companies that have unexpectedly hit a road bump (higher raw material costs and consequently shrinking margins: Coca Cola in the 1980’s, slower sales or, worse, obsolescence due to new competition: Eastman Kodak–who?–and the emergence of digital film, or new, ground-breaking technology which impacts the primary product offering: Hewlett Packard in the shadow of the iphone and ipad).  Because growth stock investors tend to focus on price momentum they are rarely patient with earnings misses and often unload the stock at the first sign of weakness.  The fallen-angel stock presents a great opportunity for the value investor but the important thing is not to become too eager to buy a former growth icon.  Value investors must remember that growth stock investors can and will bail out of a stock much quicker than the more price sensitive investor can accumulate holdings.

So, what to do?

As soon as a stock disappoints, add it to your wish list.  Begin tracking the price.  And wait.  The former darling will pass through the three stages of stock market grief:  disappointment, hate and finally, neglect.  Neglect is the point when the stock price flat lines:  the intelligent value investor’s buying opportunity.

Next post we will examine the price performance of an actual fallen-angel growth stock.