It is a defining characteristic of Foolish Investing. It is a point of honor among many, here on this board, and elsewhere. It is tax efficient, has been shown to promote higher returns, and encourages one to think of ‘companies’ instead of ‘stock symbols’. It is, of course, “long term investing”. But, what exactly is long term?
I have always taken the rather pragmatic view that “long term” means “until the investing thesis is broken”. For example, here on Saul’s board, we focus on buying solid rapid-growing companies that the market has failed to reward with P/E multiples that most would consider ‘normal’.
Suppose we discover that “XYZ” company is growing EPS by 60% per year, has solid financials, and a wide-open addressable market. Yet it is trading at a P/E ratio of 20. After much research and discussion, we decide that the 1YPEG of 0.33 is too good to pass up. So, we invest.
And we hold.
The price goes up (Yay!), but the earnings continue to grow faster than the stock price. The 1YPEG drops next quarter to 0.25. We buy more.
Then Mr. Market starts to notice. Mutual funds begin buying XYZ stock. Cramer talks it up on his show. The price begins to accelerate upward. Next quarter, the 1YPEG grows to 0.5. Then, a quarter later, it swells to 0.8. And then, the company decides to invest heavily in a new plant to support the growing demand for its products. They pay for the plant out of cash flow – earnings take a huge hit. The PEG swoops up to 2.5, then 4.0 as earnings growth fizzles for the next two quarters.
What do we do?
For me, I would say that the company is still executing well, and a temporary hiatus in earning growth to invest in future manufacturing capabilities is a very wise move. I would gladly hold this company in my portfolio, expecting earnings growth to resume once the expense of the new factory is over. Even if the price drops considerably, I would still hold this company. The investing thesis is not broken, and there is no evidence that the company will not continue to grow, perhaps even faster now that additional capability is brought on-line.
Now let’s assume we look at “ABC” company, which is also a healthy, growing company sporting a 1YPEG of 0.33 when we begin our research. It looks to be well positioned for continued growth, possesses flawless financials, and has accelerating earnings growth. We invest.
Three quarters later, a competitor has a major technological breakthrough, rendering their product much more effective for half the cost of ABC’s offering. Earnings stumble, and the company’s earnings call has the feel of a funeral. The 1YPEG stays roughly the same (around 0.33), but that is because the P/E ratio has tumbled in line with the fall in earnings growth.
Do we sell?
Yes! The investing context for ABC has changed, thus invalidating our investing thesis. Though we have only owned this company for 3 quarters, it is time to sell and re-purpose the funds we salvage to another candidate company.
Are we now no longer “long term investors”? We just got in and out of a company in less than one year! Heaven forbid, we actually incurred either a loss, or a short-term taxable gain! I maintain that yes, we are indeed long-term investors. Only at the extreme (Phillip Fisher comes to mind) are investors unwilling to sell if the circumstances warrant it. I think that such short-term sells would be rare, especially if we always fish for high-quality growth companies. Rare, but not impossible.
Like “zero tolerance” rules, buy-and-hold-forever is just an excuse not to think. Do I think we should be trading frequently based purely upon price movements? Not at all. I think we should enter every purchase of a company’s stock with the intention of owning it for a long, long time. But not necessarily “forever”, and certainly not “despite changing circumstances”. The evidence is overwhelming that trading less often is almost always good for your financial health, but never selling? That is like flying an airplane but never learning how to land. The flight is fun, but the end can be sudden, and unpleasant.
So, fellow investors, let’s strive to use our heads, to manage our emotions, and to invest in great “tiger companies” at prices well below what the market usually rewards growing companies with. Then let those companies and all of their employees work to compound our wealth over time. But, if our tiger proves to have changed its stripes, or if a bigger tiger moves into the neighborhood and starts eating all the prey, we must be smart enough to sell our position and find a better place for our money.
THAT, to me, is “long term investing”. And I think that is the approach that Saul seems to take as well.
Tiptree, Fool One guide, and fellow investor