Q: What kind of prerequisites make long-term investing successful?
A: More specifically, invest in mid-cap stocks because you have a better opportunity to own these stocks in the high return part of their life.
Another crucial factor to succeeding in long-term investing is to be patient. Stocks seldom go up the minute you own them. It usually takes years to make big returns, and there are long periods of time when you make little progress.
Q: How would you define mid-cap?
A: We actually began defining mid-cap stocks in the mid-70s using revenues and simply eliminated the 150 largest companies ranked by sales in the Fortune 500, which eliminated half the stock market capitalization. Now everyone uses market capitalization as a proxy. Mid-cap stocks are between $1 and $15 billion.
Q: How has investing evolved over the last twenty-five years?
A: The thing that has changed a lot is access to information and screening ability. Earlier, we used to get financial data from Compustat by “snail mail.” Now it’s available in seconds. The essence of what we do is truly the same. We look at companies that have great managements, new products, service, large markets, and the ability to grow earnings at a rapid rate.
From a performance standpoint, one of the shortcomings in our investing was that we tended to think we could look through the downside volatility. We have modified the way we invest to be more sensitive to minimize downside exposure without giving up good upside potential.
Another simple observation is that in the 1970s we made money in oil and energy. In the 1980s and early 1990s, we made money in healthcare; and in the mid and late 1990s in technology. Today, we are continuing to make money in technology, energy, in certain consumer areas, as well as in materials and industrial stocks. So there has been an evolution in the sectors that have provided us the best returns.
The economy today has as many problems and opportunities as it did in 1975. We have had this long bull market in bonds that had some impact on stocks by allowing P/E ratios to rise. That can’t be repeated, so stock returns will be lower in the next ten to twenty years than they were in the 80s and 90s.
Q: What metrics drive the long-term investment process? Could you illustrate with a few examples?
A: Good money managers have an ability to find great stocks. Naturally, finding a great growth stock is quite different from finding a very good company when it is depressed.
The first metric we focus on is size. For instance, we cannot do as well in Exxon as we will be able to do in a medium-sized energy company. Exxon is a very well-run company, but too big to grow fast. But if we want above-average returns, we must find companies at a reasonable price that can grow a lot faster than the market.
Also, we have to realize the power of bear markets and demonstrate some caution. A great example of that would be Amazon, which has been a very good stock since it came public. Yet, during the 2000 bear market, it was very painful to own the stock.
Furthermore, the continual search for new growth companies is critical to a good long-term investment process. Growth stocks can frequently come out of companies that have done nothing for ten, or twenty, or thirty years, or IPOs, turnaround situations, or from companies that have launched a new product.
A classic illustration of that would be the S. S. Kresge Company, one of the 20th century’s largest and best-known retail organizations. The company was renamed Kmart Corporation in 1977. In 1968, we began buying shares in Kresge, and it offered a 5% yield and traded at eight times earnings and was considered a bond.
Kresge was a slow growth, mature retailer that invented the big box discount store. Ultimately, it was surpassed by Wal-Mart, but nevertheless Kresge went from a stodgy income stock to one of the great growth stocks in the country during the 70s.
This is a classic example of having open-mindedness in searching for new and exciting products and services.
In 1987, we bought two health maintenance organizations. One of them was U.S. Healthcare, and the other was United HealthCare, which has compounded at 20% plus since 1987. It helped drive out returns. By the way, we bought it and sold it three or four times. The history of Cisco was much the same. These were leading companies in new industries.
Q: Has the perception of risk improved in the last three decades despite the advancement in technology and availability of data?