Someone emailed me this question:
“Buying just one stock a year and holding for five years does have its strong merit, but to immediately move to this approach, what kind of flexibility one will have to adopt.
I got the basic idea, i.e. to buy as few stocks for as long a period as possible.
But, then, should one absolutely lock-in the stocks, or can one shift to some other securities in the meanwhile…that could become more attractive?”
Theoretically, there’s nothing wrong with switching out of a stock you own for a better stock you don’t own. It’s always a good idea to move from more expensive stocks to cheaper stocks and from good businesses into great businesses. The problem here is the difference between what works in theory and what works in practice. A purely rational investor doesn’t need any sort of rules, principles, etc. to make good decisions. He is just rational all the time. And his rationality leads to always making the best decisions given the information he has. In my experience, people aren’t rational. They have a bias toward more activity instead of less. So, when an investor owns a stock for a few years – he starts to get bored with it. He starts to get bored waiting for the stock to move.
I’ll give you an example. I’ve owned Frost (NYSE:CFR) for a couple years now. In 2015, the stock did absolutely nothing for me. In 2016, it was probably up something like 40% while the S&P 500 was up maybe 10%. What was different about 2016 from 2015? For Frost as a business, 2016 wasn’t better than 2015. It’s not like the business underperformed my expectations in 2015 and then outperformed my expectations in 2016. It’s just that bank stocks were more popular in 2016 than they had been in 2015. Investors were more interested in buying bank stocks in 2016 than they had been in 2015. Why? Probably because they felt the Fed was more likely to raise rates sooner. In 2015, rate increases seemed a distant and uncertain prospect. Now, at the start of 2017, rate increases seem very near and very certain. That’s what caused Frost's stock to rise.
A lot of people would get bored holding Frost stock through 2015. They might sell the stock before 2016 ever came around. Before you buy a stock, you often have this idealized view of the future. So, if you expect a stock to return between 10% and 20% a year over the next five years, you don’t really think that will come in the form of a 10% drop in the stock price in year one, a 50% rise in the stock price in year two and then a very flat performance in the three years after that. But that’s exactly how it happens sometimes. A lot of investors will miss out on the years where a stock is up something like 50%. But even pretty boring stocks – Frost is a pretty boring bank – have years where they rise almost 50%. If you miss out on owning the stock in a year like that, you can miss out on most – or even all – of what that stock will return over five years or so.
I think it’s best to commit to the idea of holding a stock for a certain period of time on the day you buy it. So, I think it’s a good idea when buying a stock in 2015 to plan to hold that stock through 2020. I also think it’s a good idea to judge your performance in that stock choice based on how it does over the full period you intended to hold it for. In other words, if you bought Frost at the start of 2016 and it went up 40% or so, and then it doesn’t do anything for the next four years – I think you have to look at that as if your stock pick was only good for a less than 10% a year gain over five years, rather than a nearly 50% gain over one year. I think that’s true even if you sell the stock right now. That’s a strange thing to say. Shouldn’t you judge your performance based on your actual buying and selling of stocks?
I don’t think so. That’s how a trader should look at their performance. But, an investor should look at how their stock pick did as an investment, not as a trade. A one-year holding period isn’t an investment. Anything you buy and sell within one year is a trade. Something you hold for five years is an investment. If the stocks you pick have only mediocre five-year records, but they do well over the time you actually own them – that’s great. It means you’re very smart. But it means you’re a very smart as a trader. You’re not a very smart investor. A smart investor would have picked stocks that would continue to do well over an investment type holding period.
Look, you’re going to break your own rules. That’s bound to happen. So, when I say you should have a rule that you always hold a stock for a full five years, I know that isn’t going to translate into you never selling a stock within five years. But, I also know that if you don’t have any sort of rule at all, you’re going to sell much sooner than you think you will.
I’ve talked via email with lots of value investors; these are people who consider themselves long-term buy and hold type investors. When they actually look at the turnover in their portfolio, they always find that it’s higher than they would have guessed. These investors think they are holding stocks for three to five years on average, when in reality they’re holding stocks for more like one to three years on average. If most people hearing this were to go back and look at the turnover in their own portfolios, I think they too would find that they trade more and invest less than they think they do. I certainly know that’s true for me.
There are some stocks I’ve owned for a long time. For example, I still own shares of George Risk (RSKIA). And I bought shares in George Risk in the summer of 2010. So, the holding period there is now up to about six and a half years. George Risk hasn’t outperformed the S&P 500 during that time period. Therefore, this wasn’t a good investment in hindsight. But I’ve never been worried about holding it, because the stock has always seemed cheap relative to the S&P 500. It never really went up in price very fast. And the S&P 500 did get progressively more expensive while I owned George Risk. So, I never regretted making the purchase. The stock just didn’t get bid up all that much. That happens. The reverse happens too.
Let’s look at an example of the opposite happening. Let’s talk about BWX Technologies (NYSE:BWXT). My stake in this company was a result of buying Babcock & Wilcox prior to that company breaking up into two parts: B&W Enterprises (NYSE:BW) and BWX Technologies (NYSE:BWXT). BWXT is the “good” Babcock. It’s focused on things like nuclear reactors for the U.S. Navy. B&W Enterprises is the “bad” Babcock. It’s focused on things like boilers for coal power plants. This is an over-simplification of the two businesses. But it helps explain what happened after Babcock’s spin-off. BWXT stock really took off. It became very expensive very fast. Babcock as a whole wasn’t expensive at all before the spin-off. BWXT was rewarded with a blue-chip type valuation. B&W was penalized for its reliance on coal. The market reaction was very strong, very fast. What happened is basically what we expected to happen.
When I wrote the newsletter issue about the Babcock spin-off, I spent a lot of time talking about how high quality and predictable Babcock’s nuclear work for the U.S. Navy was. This part of the company wasn’t being given as high a valuation as it might be as a stand-alone company. Quan (my newsletter co-writer) and I both really liked the idea of breaking up Babcock. We liked the capital allocation plans the company had.
I rarely invest in companies with “catalysts.” George Risk is a good example of a cheap stock that lacked a catalyst. Babcock is a good example of a somewhat less cheap stock that had a catalyst. You could argue that this shows investing in companies with a catalyst is the better choice. And I’d agree with that – if you could find a reliable supply of companies like Babcock with catalysts. You can’t, however, it’s really rare. If you look at a list of all the spin-offs that have happened in the last few years, there are very few parts of any of those companies that had anywhere near the quality of Babcock’s U.S. Navy nuclear business.
I was fine buying Babcock with or without the spin-off. It’s not like I bought the company pre-spinoff and then I sold one of the new companies and kept the other. I kept my stock in both of the companies. I like Babcock’s U.S. Navy nuclear business better than something like its U.S. coal power plant installed base. Now, that’s not all B&W Enterprises has. It also does new build in other countries that is unrelated to coal. It also does environmental work. Regardless, I like the industry BWXT is in better than the industry B&W is in. But there’s nothing wrong with either company’s competitive position. So, I bought Babcock without needing to know the company was definitely going to go ahead with the spin-off. If they’d decided not to do the spin-off, I would have kept stock in the combined company. The catalyst was nice, but I didn’t think it was necessary.
Now, obviously, you could say there’s no need to hold BWXT stock for five years. The shares went up a lot and fast. So, the company became expensive quickly. It might make sense to hold B&W Enterprises for as long as five years, because that stock hasn’t performed well compared to what Quan and I thought it would be worth on its own. In theory, I don’t disagree with this. In practice, it’s a little more complicated.
Let’s get real here. Can I find another company with as strong a competitive position as BWXT? A lot of BWXT’s earning power now comes from a monopoly position serving a government customer. That government customer thinks the projects BWXT works on are among the most important projects it has. So, I can’t easily replace BWXT’s quality through the purchase of some defense contractor. Companies like General Dynamics (NYSE:GD) and Huntington Ingalls work on some of the same ships that Babcock does. But they don’t provide as important components and they don’t have a monopoly. In fact, I’d say the government prefers having two potential suppliers in General Dynamics and Huntington Ingalls.
Meanwhile, the U.S. Navy has accepted the fact there’s no alternative to Babcock as a supplier. There really aren’t other defense projects that I have as much faith in long-term as either nuclear powered subs or nuclear powered aircraft carriers. And even in the cases where I can find a defense project that I’m sure will be around a couple decades from now, I can’t know for sure who will be supplying the military’s needs. It could be General Dynamics or it could be Huntington Ingalls. It could be Boeing (NYSE:BA) or it could be Lockheed (NYSE:LMT). So, I can’t replace BWXT in the sense of finding another company with as strong a competitive position, as high returns on capital, etc. to put in my portfolio.
For that reason, I never sell a stock like BWXT just to hold cash. I will, however, sell a stock like BWXT to raise cash for a better purchase. That stock would have to be something I’d be willing to own for a full five years. Those kinds of stocks don’t come around very often. But, I do get ideas of that caliber every once in a while. For much of this year, I’ve been seriously considering Howden Joinery. It’s a U.K. stock that is reasonably priced. It also has more room for growth in sales and especially earnings over the next five years than BWXT does. It’s possible I’d sell a stock like BWXT to buy a stock like Howden Joinery.
My rule is to buy anything – even a stock with a catalyst like Babcock had – with the intention of holding it for five years. That doesn’t mean I’ll never sell a stock within five years. I’d consider selling stocks like George Risk, BWXT, etc. to buy something like Howden Joinery. So, yes, I do sell stocks much sooner than five years after I buy them. I do it all the time. Far more than I’d like. But, I try to go into every stock purchase with the idea that I’ll hold it for five years no matter what the stock price does.
When I have more ideas than money, I have to sell what I own to buy something I don’t. That’s unavoidable. But, I do my best to sell stocks as rarely as possible. And I especially try not to “re-evaluate” a position until five years have passed. I think of buying a stock as electing that business to a five-year term in my portfolio. Over time, I’ve become more and more dedicated to the idea of owning as few stocks as possible for as long as possible. That’s the ideal. I usually fall far short of it. But, over the years, I have succeeded in inching closer to that ideal.
Disclosure: Long CFR, BWXT, BW, RSKIA.