The world is full of stock traders.  They firmly believe that they can trade stocks and create unlimited wealth for themselves and their families.  These traders could be your neighbor, your co-worker, your physician, your lawyer, and even your CPA.  But traders can also include professionals entrusted to take care of other people’s money.  They are mutual fund managers, managers of pension plan assets, managers of separate accounts, and hedge fund managers, many of whom you would think know better. 

It is easy to understand why so many have fallen under the spell of trading.  Just pull a chart on any individual security or index and look at the change in price from low to high.  If you look hard enough you will see a pattern.  Once you see the pattern, it is easy to believe you have found something special that will make you rich.  After all, you are just as smart as everyone else, and to prove it all you have to do is buy and sell.

There are some problems with trading your way to riches.  There are commissions, taxes and all the work needed to account for trade after trade.  Then there is the fact that so many people have tried and failed.  Although I cannot prove it, I would opine that very few, if any, individual investors, trading on their own behalf, have walked away with real profits.  Even the great trader Jesse Livermore, whose fictional biography Reminiscences of a Stock Operator is one of the most recommended books by actual traders, died broke.

For most of us, there is a better way that is easy to implement and has a history of growing wealth.  Buy great companies and just own them for a long time.  This is not a new idea!  But because year after year, month after month, and day after day we are bombarded with the idea that we can trade our way to wealth, it receives very little attention.  So I thought I would send a little reminder that the other way, buy and hold, has a great record of success.

Warren Buffett and his partner Charlie Munger are possibly the most well-known champions of buy and hold.  In their 1988 Shareholder Letter they stated, “We expect to hold these securities for a long time.  In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”

Another manager that deserves recognition is Chuck Akre, who founded Akre Capital Management in 1989.  He managed the FBR Focus Fund for years, earning returns that were some of the best in the industry.  Since 2009 he has managed Akre Focus Fund, where he once again has performed brilliantly.  He is famous for describing the type of companies he owns as “compounding machines.”  These are businesses that are capable of compounding shareholders’ capital at high rates for long periods of time with little risk of permanent loss of capital.

Chuck, like myself, was influenced by Thomas W. Phelps and his book published way back in 1972, 100 to 1 in the Stock Market.  I will let Chuck introduce Tom, whose words we are going to share with you, as Chuck did with the attendees of the 8^th Annual Value Investor Conference held in April 2011:

In 1972, I read a book that was reviewed in Barron’s and this book was called “100 to 1 in the Stock Market” by Thomas Phelps.  He represented an analysis of investments gaining 100 times one’s starting price.  Phelps was a Boston investment manager of no particular reputation, as far as I know, but he certainly was on to something which he outlined in this book.  Reading the book really helped me focus on the issue of compounding capital.

Here are the five reasons to buy and hold great companies according to Thomas Phelps:

1.  There is always a market for the best of anything, because people who appreciate quality always seem to have money.  That is true of stocks and bonds as it is of real estate and antiques.
2. Buying for maximum long-term growth avoids the pitfall of underestimating other people.  When you buy because you expect the earnings and dividends to increase one hundredfold in the next twenty, thirty, or forty years you are not planning to unload on someone less brilliant than yourself.
3. When you buy a stock with a superior profit margin, an above-average rate of return on invested capital, and sales that are growing faster than the industry’s or the country as a whole, you have time on your side.  Never bet on a possibility against a certainty.  Time marches on, and will continue to march on.  That is a certainty.  If your stock has no visible ceiling on its indicated growth, time will correct many errors in what you pay for your initial commitment.
4. The old saw about the world beating a path to the door of the man making better mouse traps may be corn but it is high protein corn.  It is sometimes denigrated on the ground that without the help of Madison Avenue the better mouse trap maker would blush unseen.  In real life anyone smart enough to make a better mouse trap would not stop there.
5. “Don’t marry a man to reform him,” a wise mother counselled her daughter.  It is seldom profitable to marry a stock to reform it either.  Sometimes, as with husbands, the hoped for reform never comes.  Even when it does come, it is often sadly delayed.  Hope deferred maketh the heart sick.  Your turnaround candidate may double in price, but if you have to wait ten years for it to happen your gain is at the compound annual rate of only 7.2%.

And a few other words from Tom:

Perhaps the greatest advantage of all in buying top quality stocks without visible ceilings on their growth is that when we do so we give ourselves the chance to profit by the unforeseeable and the incalculable.  Year after year mankind achieves the impossible but persists in underrating what it can and will do in the future.

Thomas Phelps’s book 100 to 1 in the Stock Market highlighted 365 companies that produced a 100 to 1 profit over the 40 years prior to 1971.  Some required the entire 40 years, others took less than five.  In each case a $10,000 investment grew to $1,000,000.  For those who care, a 100 to 1 payoff over forty years requires a constant annual growth rate of 12.20%.  For those who really care, the average annual return of the S&P 500 (including dividends) for the forty years ending December 31, 2013 was 12.62%.

The next forty years may not produce the returns experienced by Tom’s generation or my own, but odds are that long-term investing in great companies will produce far greater returns than the false promises of day to day trading.

Until next time,

Kendall J. Anderson, CFA