Patience and Performance

June 4, 2008 by Joe Ponzio

When you buy stock in a company, how long do you plan on holding it? Forever. Ideally, yes. But we live in the real world – a world of wildly fluctuating stock prices that often turns otherwise sane investors into panicky, self-doubting lemmings. As stock prices drop…lower…lower…people tend to second-guess their decisions and sell precisely when they should be buying.

[W]hile I realized thoroughly that if I were to make the kinds of profits that are made possible by the process that I have described as zigging when the rest zags, it was vital that I have some sort of quantitative check to be sure that I was right in zigging. With this in mind, I established what I called my three-year rule. – Philip Fisher, Common Stocks and Uncommon Profits

If you haven’t read – that is, memorized – Common Stocks and Uncommon Profits, do it now (it’s just $13). When Buffett says, “I am an eager reader of whatever Phil has to say,” it would behoove us to be avid readers as well. I’m going to spend the next few weeks on Fisher, covering topics from analyzing management to investor psychology; still, I suggest you pick it up and dive in for yourself.

I have repeated again and again to my clients that when I purchase something for them, not to judge the results in a matter of a month or a year, but to allow me a three-year period. pages 244-245

Holding On For Three Long Years

We all know that intelligent investing requires patience and discipline; still, it is easy to forget how long “three years” really is. Let’s put this into perspective:

  • I feel like I’ve been writing forever. With its first article appearing on June 25, 2007, F Wall Street is not even a year old.
  • Don Imus? Old news. Well, not that old. He was fired on April 12, 2007 – just over a year ago.
  • Google and YouTube have been together forever, right? Wrong. October 10, 2006 – Google buys YouTube for $1.65 billion. Twenty months ago.

It feels like these things happened a lifetime ago. In reality, you should be ignoring the performance of the stocks you purchased recently and over the past thirty months. Instead, take a look at the ones you bought when Michael Jackson was acquitted in June of 2005, or when Grand Theft Auto San Andreas was released that same month. Take a look at the performance of the ones you purchased as Lance Armstrong was the first to cross the finish line of the Tour De France, for his seventh time, in July of 2005.

Whether I have been successful in the first year or unsuccessful can be as much a matter of luck as anything else. In my management of individual stocks over all these years I have followed the same rule, only once having made an exception. page 245

Price Follows Value, But How Quickly?

Why would Fisher create a “three-year rule” for holding stocks? Though he doesn’t outright say so, Fisher noted that, on average, it takes up to three years for the markets to turn from pessimistic (or ignorant) on a company to rational or optimistic. This, of course, begs the question, “How many times did he sell prematurely, only to find that the stock prices soared after his sale?”

Actually, there have only been a relatively small number of times when I have made a sale triggered by this three-year rule and nothing else…However, in those relatively few cases where it was the three-year rule and only that which caused me to sell, I cannot recall a single case where subsequent market action caused me to wish I had held on to the shares. page 247

Violating The Three-Year Rule

When should you violate the three-year rule? Buffett has said that his ideal holding period is “forever.” Fisher says three years. Does Buffett violate the three-year rule? I don’t think so.

There are three main components to Buffett’s portfolio: Workouts, Generals, and Controls. His portfolio was constructed that way in the early partnerships, and it remains this way today. His arbitrage strategies fall under the Workouts category; Controls are the businesses that Berkshire owns outright, or that it owns as permanent positions (eg. though Berkshire owns 8.6% of Coca-Cola, it can be said that Buffett is in a controlling position of this company that he has declared a permanent position); Generals are stocks Buffett purchases that he subsequently sells.

For example, in April of 2004 Buffett began buying Comcast. Over the next three years, he added to his position, bringing his total ownership to twelve million shares. During that time, Comcast’s business has continued to grow, though the stock price has gone nowhere. Every quarter and each year, Buffett will look at Comcast and ask himself one simple question: Will this company be worth more in five years than it is today?

Why would Buffett violate the three-year rule? He wouldn’t. Fisher does not advocate selling “no matter what” after three years. Instead, Fisher teaches that we need to give our companies three years to achieve what we believe they should. If, after three years, the company has failed to meet or exceed our expectations, then we should sell, even at a loss.

Otherwise, the intelligent investor would be wise to reevaluate his/her companies each quarter and year, and ask the question: Is this company striving to meet my expectations? If so, can I adjust my expectations higher and reset the three-year clock? If not, perhaps the company needs more time, but not more than three years from my original purchase.

Some Guidelines To Selling

I figured it was best to start Fisher with a “When To Sell” discussion simply because of recent market activity. As the markets drop, it’s easy to lose focus on the long-term (now we know that means “three-year”) picture and fixate on daily price movements.

Building on a post I wrote on April 17, 2008 – The Art of Selling Your Stocks – let’s lay down some further guidelines to selling:

  1. Sell when the company is no longer attractive from a business perspective; or,
  2. Sell when you are no longer comfortable with your valuation versus the price, either because the price has increased, the value has decreased, or the valuation has become murky; or,
  3. Sell when a “no-brainer” turns into a “I’m not sure anymore”; or,
  4. Sell after three years, unless you believe the company is still underpriced and has wonderful future prospects, after a thorough analysis.

#1: Business Perspective

When the company is not longer attractive from a business perspective, get out. This could be because new management is padding salaries, or the company isn’t willing to change with the times. In essence, it is a fundamental change in the business, turning a good or great company into a mediocre or bad one, not because the company (and its industry) fell on hard times, but because the nature or direction of the company has changed for the worse.

#2 and #3: Price and Valuation

I talked about two recent positions that I sold where two and three came into play. With Graham Corporation, I sold because I was not entirely comfortable with the valuation (#2), because the company was changing rapidly. I felt it was underpriced, but I wasn’t sure how underpriced it was. With the Nutrisystem bonehead move, I was somewhat comfortable with the valuation of mid- to high-$30s. At $19 a share, I wasn’t excited to buy. At $13 a share, it was a no-brainer. Once it ran up again to that “I’m not excited” price, a sale would have been in order.

#4: The Three-Year Rule

Practice your assiduity. Check in on your companies to see that they are working towards meeting your expectations, even if the price and short-term financial statements suffer somewhat. Give them time. Give them at least three years. If, after three years, management can’t get the company together, sell and move on to another opportunity.

So, if you buy stock today, check the quarterly and annual reports, and be prepared to act quickly. You’ll want to sell in June of 2011 if things aren’t working out. Until then, close your browser and enjoy life a little.

A Note From Joe Ponzio

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