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The secret of investment success: knowing how to hold

When is a stock worth holding? There’s no need for guesswork, says this advisory, which identifies guidelines and stocks that pass the test.

We promise not to use any poker analogies like “knowing when to hold ‘em.” Because holding a few cards for a matter of minutes and holding a stock over time are not one and the same thing.

But there is little doubt that one of the touchstones of investment success is knowing how long to hold a stock — and judging the right moment to let go of it. Or, as Wall Street legend Peter Lynch has said more than once, the key to making money is not to get “scared out of your stocks.”

And since we are now in the midst of one of those times that try investors’ souls, there is no better time to look at what is worth holding.

Obviously, the trick is to determine whether a stock is worth keeping before you buy it. It helps to have a set of guidelines. We find a well-defined set of criteria laid down in Dow Theory Forecasts.

This U.S. advisory sets down four basic characteristics to identify the perfect buy-and-hold stock, or what it calls an “easy hold.”

Two easy Canadian holds

We should say at the outset that the advisory also publishes a list of “Easy Hold” stocks and that two of those stocks are Canadian: one is SunLife Financial (TSX/NYSE-SLF), the other is Manulife Financial (TSX-NYSE-MFC).

Both are rated as Long-Term Buys, though neither is among the four stocks highlighted in the article on “easy holds.” And while not many financial stocks are getting into the positive spotlight these days, it’s worth noting that Canada’s big insurance firms appear to be refreshingly free of the taint of asset-backed securities.

But now it’s time to see what makes these and other stocks so eminently holdable.

Consistent, steady, dependable

The first characteristic of a good buy-and-hold stock, says the advisory, is consistent fundamentals.

“The best easy holds generally have steady and dependable track records of revenue, earnings and dividend growth,” says the advisory. “Such consistency limits surprises and reduces the volatility of returns.”

Consistency may seem a little dull, but in those times when the market bounces around, it starts to look a lot better.

The second criterion is based on the same predictability: consistent share price performance regardless of market conditions. The advisory admits this may not be terribly exciting, either.

“The best easy holds neither lead nor trail the pack in terms of annual performance. Rather, easy holds tend to provide consistent, albeit unspectacular, gains on an annual basis.” Again, steady beats spectacular.

“Stock volatility, unfortunately, often drives investment decisions,” adds the advisory. “Said differently, investors feel they need to react when stocks exhibit big moves in either direction. With easy holds, the lack of price volatility limits the urge for action.”

Lots of money

The third characteristic is also disarmingly simple: having lots of money. The advisory defines it as strong finances. “Easy holds have the financial wherewithal to survive and thrive over the long term.”

Consider how many large financial institutions have had to dig into their very deep pockets to allay the admittedly self-inflicted crisis brought on by bad credit. By the same token, well-heeled companies who, through no fault of their own, see their share prices decline in a market correction need have no fear of the long-term consequences. Nor do their investors.

Finally, the stock must have reasonable valuations. “Valuation always matters,” says the advisory, “whether you are investing for the short or the long term. The best easy holds are not necessarily bargains but offer reasonable valuations relative to their growth prospects.”

Not content with listing these four criteria, Dow Theory Forecasts went on to rate stocks based on four specific measurements that reflect these characteristics. In short, they looked for consistency in the numbers.

Worst-case scenario

It starts with the worst-case scenario. What is the worst three-month performance for a stock over the past 60 months? To do this the advisory used rolling three-month total returns. Rolling returns detail every 12-month period in a stock’s performance and give a better measure of volatility than trailing returns, which are tied to specific time periods.

Next comes standard deviation of risk. While this sounds a bit technical, it is a simple calculation: how much stock prices vary, up or down, on a monthly basis. This was calculated over a period of five years.

Beta is another technical term with a simple explanation. It measures a stock’s volatility relative to the market as a whole, in this case the S&P 500 Index. If the index goes up one per cent, a stock with a beta of 1.0 should do the same. A stock with a beta of 1.2 per cent, however, would go up 1.2 per cent on the same one per cent increase by the index.

Bear market performance

To counterbalance the worst-case scenario for the stock, the advisory measured the worst-case scenario for the market. The final measurement is bear-market performance, or how a stock performed when the S&P 500 declined by at least 2.4 per cent. “While such a decline does not constitute a bear market,” explains the advisory, “it is meaningful. How stocks perform during such weak market periods should shed light on their easy hold qualities.”

The stocks reviewed were given a percentile ranking. For instance, a 97 bear-market performance meant that a stock did better than 97 per cent of the stocks in the 3,900 measured. (The advisory covers over 5,000 stocks, but only 3,900 had sufficient data for the test.)

The stocks that made the grade were those with a “Volatilty Score” of at least 80. The advisory also has its own Quadrix® ratings system for overall performance, and the stocks had to have a score of 75 on this scale.

Seventeen stocks made the grade. We’ve identified the two Canadian firms that made the list. Four stocks get special mention in the advisory.

No introduction needed

Three of these stocks are household names. The fourth is one of those big, successful companies that doesn’t make the headlines very often, but just goes on being big and successful.

Exxon Mobil (NYSE-XOM) needs no introduction. It’s simply the biggest integrated oil company in the United States. As its mature assets decline, it is making the necessary adjustments, undertaking development projects in the Middle East, Africa and Russia.

The secret of its appeal as an “easy hold,” however, stems from its history of rewarding shareholders. In the last quarter alone, Exxon bought back $7.8 billion in stock and paid out $1.9 billion in dividends, accounting for no less than 56 per cent of operating cash flow. “While Exxon is rarely the top performer in the energy sector, the company’s consistent showing should pay dividends in the event that energy stocks become more volatile,” states the advisory.

We don’t need to introduce you to Johnson & Johnson (NYSE-JNJ), either. Among the stocks the advisory has rated as Buy or Long-Term Buys, this one has the top Volatility Score: 98 per cent.

One of J&J’s strengths is that its foreign operations, which add up to 44 per cent of sales, are profiting from a weaker U.S. dollar. Aside from its well-known consumer products, it is growing rapidly in other areas, especially pharmaceuticals. The company made two large acquisitions in the past year, is making large cost-cutting efforts, and devoted 13 per cent of its budget to research and development last year.

The result: the shares have performed well when the market’s down and recently posted new highs. Just what the doctor ordered in markets like these.

Snoopy and the blimp

Thanks in part to its astute advertising use of Snoopy and the blimp, Met Life (NYSE-MET) has also become a household name. It is the largest life insurance company in the U.S. with some $3.6 trillion of insurance. It also deals in group health insurance (an area of obvious urgency in the U.S.) and financial services.

International operations are less than 10 per cent of Met’s overall tally, but they’re growing, with Latin America and Asia both forging ahead. “Met Life has been aggressively repurchasing stock,” adds the advisory, “buying back nearly $1 billion in stock in 2007 and in September authorizing a new $1 billion buyback program.”

The stock is attractively valued. Despite its strength, it trades at only 10 times estimated earnings for the year ahead, and at a lower price/earnings ratio than its peer group.

The non-household name in this group is Sigma-Aldrich (NASDQ-SIAL). The name is very well known, however, to the universities, hospitals and commercial laboratories in 165 countries to whom it sells more than 130,000 chemicals and biochemicals.

Foreign sales make up 60 per cent of earnings, and earnings have grown by 18 per cent over the past five years. The performance of the stock has been downright phenomenal: a trailing 12-month total return of 39 per cent, a three-year annualized return of 19 per cent and a five-year annualized return of 19 per cent. And the company continues to pursue growth aggressively.

Sigma-Aldrich has increased its dividends every year since 1975. And the stock continues to trade near its all-time high. “These shares could pull back in the near term should the overall market decline,” admits the advisory. “Nevertheless, the stock should handily outperform the overall market over the next 24 months.”

Here, listed in the order of highest to lowest Volatility Scores, are the remaining 11 stocks that made the “easy hold” list: PepsiCo (NYSE-PEP); Aflac (NYSE-AFL); Lockheed Martin (NYSE-LMT); natural gas specialist Energen (NYSE-EGN); Wal-Mart Stores (NYSE-WMT); Chevron (NYSE-CVX); electronics maker AMETEK (NYSE-AME); United Health Group (NYSE-UNH); pharmaceutical firm AstraZeneca (NYSE-AZN); Australian communications giant Harris Corp. (NYSE-HRS); and biotech firm Laboratory Corp. (NYSE-LH).

You may find a few surprises in this list, but the point is that you don’t want surprises from the stocks you are holding through thick and thin. Consistency may be dull, but when you see the market tumbling — and your stocks doing just fine — dull is great.