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.

Use Market Weakness to Buy Great Companies at a Discount

On Monday the market pundits were heading full speed for the exits.  Italy’s election and bearish Fed meeting notes were blamed for the sell-off.  Adding further uncertainty was the looming sequester.  For two days the sky was falling and as they are wont to do the experts extrapolated short-term data to conclude the market had moved too far too fast.  That was Monday.  
 
Tuesday the DJIA rose 115.96 points (.84%) and Wednesday the index rocketed 175.24 points or 1.26%.  The reasons subsequently proffered were clarification from the Fed that it would continue easing (read:  the Fed will continue to buy treasuries and mortgage-backed securities to ensure interest rates stay at current historically low levels) thereby forcing investors seeking yield and total return into riskier assets, like stocks.  Traders believe this is good for the market.  And, bam, the rally that wasn’t suddenly is once more.  
 
For individual investors this head-spinning day-to-day volatility is no way to make stock buy and sell decisions. We can’t compete with Wall Street traders.  Nor do we have to.  
 
When the frenzy begins, step back and take a good look at your portfolio.  Are you properly diversified?  Do you have an inordinate concentration in tech stocks, for example?  Or in one holding?  Are you missing exposure to a particular industry, say cyclicals?  If so, take a look at  the industry leaders to determine if there are any bargains to be had.  After the election in November when investors were worried about the impact of rising taxes and the then Washington crisis du-jour, the looming “fiscal cliff,” the market sold off and I saw an opportunity to increase my holdings in cyclical stocks (among other industries).  
 
Caterpillar (CAT) was coming off a lackluster year and the trailing p/e on the stock was hovering around 9x 2011 earnings, a significant discount to its historical average of 15x trailing earnings.  Analysts, while admitting it was one of the deepest discounts ever applied to the stock, were also quick to cite the global economic slowdown as a reason not to own the stock.  But the price was already reflecting those concerns.  I began picking away at the stock and continued to buy as it went up.  My average cost is $86.99.  The stock recently spiked at close to $100 and has come back to the low $90’s closing yesterday at $92.49.  If it spends more than a few days below $90 per share I’ll be adding to my position.  
 
As a long-term investor I don’t need CAT to return 50% in six months.  I am look for 10-12% per year which means that some years I may get 3% and some years I may get 20% or a decline of 10% but, every year I will be collecting my (currently) 2.25% dividend yield which beats money market or intermediate bond returns and I have the potential for dividend growth and price appreciation. 
 
Of course there is the risk the stock will decline.  In fact, because it is a cyclical stock and its earnings are subject to the ups and downs of the economy, I expect to experience periods when the stock declines.  That is why I own a portfolio of stocks and why I only purchase shares of well-managed companies.  However, good management will find a way to get the company back on track.  And they almost always do.  I am owning this stock for the total return it will produce over the next ten to twenty years not the next few weeks.  Look at the chart below courtesy of  Wells Trade.  I have selected the longest period availble and compared the performance of CAT with the S&P 500.  You will note that some short-term periods have not been good for the stock (or the market for that matter) but over the long-term, in good economic times and bad, CAT has produced an enviable return.  
 
 
Price chart, Wells Trade
 
I am willing to take the short-term risk when I buy high-quality companies at discounted price levels.  Frequently the lower price already reflect the risk.  As I repeatedly told my teenagers:  learn to manage expectations and you will increase your chances of success.  Stocks that Wall Street hates,  if their managements adequately manage expectations, often provide great long-term opportunities.