Fool's Eye View

[ April 20, 2000 ]

Long-Term Buy and Hope

By Maynard Paton (TMFMayn)

Carburton Street, London --When it comes to holding individual equities, we've all heard that well-worn phrase "long-term buy and hold". Indeed, it is a core part of the Foolish philosophy of stock market investment.

There are no end of studies have found that direct equity investment, over a five-year period or more, almost always beats the returns from gilts and building societies. I won't bore you with all of the figures, but you may wish to have a peek at Step 5 of our Foolish Ten Steps to get some idea of this equity outperformance.

That superior historical achievement from the stock market is good news for those investors effectively buying the market through an index tracker and then intending to use the long-term buy and hold (LTB&H) strategy. But is LTB&H suitable for most individual companies?

The evidence for LTB&H can be compelling. Everyone must have heard about Warren Buffett, and how he became worth $30b through buying and holding great companies. A few large, well-considered purchases have turned Buffett into an investing deity. Buffett has given a few examples of the benefits of LTB&H in his time. His example of Coca-Cola (NYSE: KO.), growing from a flotation price of $40 in 1919 to the equivalent of about $4m a share today is the stuff of LTB&H dreams. Buffett was relatively slow to catch on to Coke though, buying his first shares in 1988.

One other great "if you'd bought at the float" example is Microsoft (Nasdaq: MSFT). Going public in 1986 at 15 cents a share, the shares are now valued at around $78. That equates to a 35% compound investment return. Closer to home, Sage (LSE: SGE) listed on the Stock Exchange in 1989 at 4p a share. Sage shares now stand at 664p and have given lucky shareholders an average 60% annual return over the 1990s.

Then there's the quaint story of Rosa Elizabeth Hargreaves whose husband held Glaxo Wellcome (LSE: GLXO) shares from 1949. Her fortunate son inherited £6m of Glaxo stock last year. And I'm sure you can think of other long-term winners too. America Online (NYSE: AOL) springs quickly to my mind.

The point to note about these and all the other long-term winners of years gone by is that they all had ample scope for increased revenues. Apart from the likes of Coke, most are, or were, firmly based in the "industries of tomorrow". So, to a certain extent, the greatest long-term winners of the future will currently be at quite an embryonic stage and perhaps operating in sectors such as software, media, the Internet, microchips, telecommunications and biotechnology.

Granted, there will be winners in "traditional" sectors, such as finance, oil and retail. But it's unlikely the best from these industries will have the capacity to outperform those establishing footholds in mass-market but currently immature sectors.

The trouble is when reviewing the long-term greats (a sort of Hindsight Portfolio if you like) is that it's all well and good saying "if only I'd bought", but no-one takes into account the investment situation at the time.

Take Sage. If you could travel back in time to 1989, not knowing what the future held for Sage, would you have bought the shares? Think about it -- a tiny accountancy software firm? A likely long-term winner? I think not. If you were clever enough to spot Sage in 1995, at the time having a five-year growth record but languishing on a price to earnings ratio of around 25, you still could have made a handsome return. But then, how many people did notice the then £250m firm? Not many, I bet.

Or imagine Glaxo back in 1949. Was Glaxo the same industrial powerhouse fifty years ago that it is today? I don't think so. So, did the aforementioned Mr Hargreaves take a punt on an unproven biotech? Or perhaps he bought a handful of "possibles" in the hope that one may come good. Was Mr Hargreaves' purchase the equivalent of someone today taking a pin to the Financial Times and buying shares in Alizyme (LSE: AZM), British Biotech (LSE: BBG) and CnNeS Pharmaceuticals (LSE: CEN) and then tucking them away in the bottom drawer? No doubt the Hargreaves family would have been derided as a biotech gamblers in 1949. Fifty years on, they're now astute investors.

And all this apparent "gambling", to a certain extent, is the problem. If, as I suggest, the real winners of tomorrow will be created from immature industries with lots of further potential, then looking for companies with an established track record of growth may not be the way to go. Once you've waited for a proven record to develop, a substantial proportion of your share price gain would have been missed. And of course, when the superior proven record is established and everybody is aware of the potential, the company ought to be valued quite richly by the stock market, making future stock price gains less attractive.

Though there may be a few exceptions, like Sage in 1995 or Coke in 1988, companies with a demonstrable record operating in a growth area do tend to have eye-watering valuations. Call it the efficient market hypothesis (or the $1000 Twinkie theory), but companies such as Microsoft have always appeared expensive.

And given that companies with a proven growth record usually look a little pricey using traditional valuation measures, it not surprising that companies without the proven growth record always look expensive too. If your company is without profits, or indeed sales, but solely has a good idea and a high cash-burn, then just about any valuation could be considered "too high".

So what's the ambitious investor to do for the long term? As someone who personally invests for the long-term and broadly follows the guidelines of the Qualiport -- guidelines where looking at company past records is all-important -- I've become increasingly envious of the gains to be had by simply looking forward. Looking forward and hoping, that is.

Although I've probably been critical of Fools "punting" in the past, lecturing on the musings of Buffett and the importance of valuation up high from my Qualiport ivory tower, I guess a spread of "boom or bust" investments can be quite Foolish. You only need to have been an early shareholder of Dell Computer Corporation (Nasdaq: DELL) or Amazon.com (Nasdaq: AMZN) to realise that it only needs one company to make an investment career. Of course, the shares of either Dell or Amazon would have been deemed expensive at just about any point on their early growth curve. And there undoubtedly would have been more hope than analysis in any original investment "buy" decision at the time.

Anyway, to put this long-term buy and hope theory to the test, I'm going to create an imaginary ISA. In goes my £7,000 and £1,000 each for my selections for the long-term. I'm looking at growth industries and small companies hoping to ride their respective industry waves. OK, I admit it. I'm punting for the next Sage or Glaxo.

So, here's my random choice of long-term hopefuls, then:

Company                                       Price

NetBenefit (LSE: NBT)                          730p
Lastminute.com (LSE: LMC)                      176.5p
Freecom.net (LSE: FEE)                         252.5p
Telspec (LSE: TSP)                             110.5p
Cambridge Antibody Technologies (LSE: CAT)    2112.5p
Profile Therapeutics (LSE: PTP)                177.5p
Xaar (LSE: XAR)                                287.5p

It should be interesting to see how this portfolio performs over the coming years. All seven have great ambitions, great risks and great potential. Remember, just one major winner will do. Will the hopeful seven outperform my actual ISA, the Qualiport or the stock market as a whole over the long term? Time will tell.

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