Finding long-term winners: the secrets of successful stocks

Buying stocks and holding them for the long term makes sense, as a consideration of the long-term performance of the stockmarket reveals: time has a way of erasing the peaks and troughs in share prices associated with exuberance and market panics. Over a long enough time period, major US and UK stockmarket indices go up, mirroring growth in the economy and corporate profits.

No seasoned buy-and-hold investor expects their investments to rise all the time. Perhaps the strategy's most famous exponent, Warren Buffett, routinely tells people that if they would panic if the value of their investments fell 50%, then they should not invest in shares. He should know: shares in his investment company, Berkshire Hathaway, have fallen this much in the past, most recently between December 2007 and March 2009.

Berkshire Hathaway's fate was not unusual. Investors who had bought shares in the S&P 500, an index of major US companies, saw it fall by more than 55% during the financial crisis, from the peak in October 2007 to the trough in March 2009. Not coincidentally, Kenneth Solow, the chief investment officer of a US wealth-management firm, published a book entitled Buy and Hold is Dead (Again) in 2009. Since the market's nadir that year, the S&P 500 has risen by more than 350%.

Even if you had had the misfortune to invest in an index fund at the pre-crisis peak in October 2007, your investment would have doubled by today (not including dividends). Bearing in mind that outcome is the unlikely result of buying on the worst possible day right on the eve of a stockmarket crash, it seems the claim that buy-and-hold is dead was wrong, again.

Hitch a ride with the stars

Shares generally appreciate over the long term, which has encouraged the growth in index-tracking funds as a cheap and simple method of buying and holding them, a strategy that makes even more sense if investors avoid the risk of buying at the worst time in the worst market by drip-feeding money into globally diversified funds. Occasionally, though, markets test the patience of investors with the farthest horizons. UK indices have risen less since the pre-crisis highs of 2007, and Japan's Nikkei 225 index remains stubbornly below its December 1989 peak.

The fear of being trapped in a moribund market is one reason some investors try to improve on market returns by picking individual shares to buy and hold. For most of his career Buffett has trounced the market. In the UK, fund managers such as Terry Smith at Fundsmith, Nick Train at Lindsell Train, and Keith Ashworth Lord, who runs the CFP SDL UK Buffettology fund, are off to flying starts. In one sense, picking individual stocks in the expectation that they will do better than the market average is a fool's errand because most shares do worse than average. The overall progress of the stockmarket is the aggregate of a minority of high-performing stocks and a majority of lacklustre, sub-par performers. Although the chances of picking some of the high performers may seem slim, you only need a couple to make a portfolio really sing.

Think decades, not days

But in another sense, buying and holding individual shares is an errand ideally suited to private investors. Unlike most fund managers, private investors need not be swayed by short-term movements in share prices because they have no business to lose when people lose faith in them due to falling prices. Neither are the expensive accoutrements of professional fund management, teams of analysts and rows of Bloomberg terminals necessary. Buy-and-hold investors can discover good companies by reading annual reports, appraising products and services, and visiting the companies, for example.

Over time, the goal of the buy-and-hold investor is to become so familiar with a business that they understand its long-term prospects better than most market traders, a task made easier by the fact that most participants in the market are not trying to gauge the long-term prospects of businesses. The key to buying and holding is to focus on attributes other than the capricious share price fundamental attributes that allow firms to prosper through thick and thin. It can take many years and sometimes decades for a company to realise its potential fully, timescales over which investors can really get to know a business.

Start with profitability

For-profit companies exist to make a surplus, which belongs to their shareholders. The hallmark of a good business, therefore, is that it has been profitable, preferably for a long time, and at least through one economic cycle. Profitability implies a company does some things well, because customers are prepared to pay more for a product or service than it costs to supply. Strong finances too are a sign of past success, as they suggest that a company has generated enough cash to fund its operations and ambitions itself.

But past profitability alone cannot define a good company because success attracts competition, which, unchecked, will whittle away at profitability in future. To sustain profitability and growth, companies must invest in the attributes that make them stand out from the competition so-called competitive advantages. A buy-and-hold investor's confidence in the future comes from what we can learn about the company now: how it makes so much money, its strategy to make more, and what could stop it. We want to see companies building on their advantages and addressing risks that could dent profitability.

A select club of companies

Over the last two years, I have selected 15 shares for MoneyWeek that should prosper over the long term. They are a diverse bunch. Only two of the companies, Dewhurst and XP Power, are in the same subsector of the UK stockmarket, electronic components, and even they are very different businesses. Dewhurst manufactures and distributes lift components and XP Power makes power converters for industrial, semiconductor, and medical equipment manufacturers. The list also includes a package tour operator (Dart, owner of Jet2holidays), Avon Rubber, a manufacturer of milking equipment and gas masks, and Howden Joinery, a supplier of kitchens.

The biggest company is the FTSE 100 clothing and homeware retailer Next, which has an enterprise value of £13bn, and the smallest is premium building-materials supplier Alumasc, worth about £60m. Firms such as Quartix, which operates a vehicle-tracking service, have grown entirely under their own steam, while scientific-instrument manufacturer Judges Scientific is the product of many small acquisitions. Yet, despite the diversity of this group, there is a great deal these shares have in common. Apart from their generally high levels of return on capital (a key measure of profitability), these attributes are not obviously apparent from the outside, but become clearer once we get to know the businesses better.

Look for the experts in their field

Victrex is the only specialist manufacturer of PEEK, a very tough yet light polymer used in an astonishing array of products, from aircraft fuel tanks to Dyson vacuum cleaners and hip implants. Victrex invented PEEK decades ago, when it was a subsidiary of once mighty ICI. ICI lost its way in the second half of the 20th century and disappeared when it was acquired by AkzoNobel in 2007. Long before that, though, Victrex was spun out of the parent company and flourished by developing higher grades of PEEK and new applications for it. Although the original patent for PEEK expired decades ago, only a handful of competitors have emerged, the biggest of which are diversified chemical companies. Competing with Victrex is tough because it has the best products, the most expertise and capacity, and has all its resources focused on PEEK.

It's a similar story at Quartix, which sells a vehicle-tracking service. It combines a cheap, no-frills device with a web-based interface that helps fleet owners keep tabs on their drivers. The source of Quartix's advantage is not the technology, which is competent, but the company's disciplined focus on one product for a large market, small fleet owners. Quartix's strategic effort goes into only developing features that the vast majority of its customers want and marketing, principally through direct sales. This sets it apart from competitors targeting large fleets with customised devices and services, an expensive and riskier proposition.

Self-reliance is a winning corporate trait

Games Workshop makes money selling model soldiers, but in growing a hobby into a £1.9bn (by enterprise value) business, the company has developed an astonishing array of interlocking capabilities. The models are characters in "Warhammer Age of Sigmar", and "Warhammer 40,000", popular tabletop wargames sold with soldiers and modelling equipment in Warhammer stores, on Games Workshop's website, and by independent stores. The Warhammer stores are run by hobbyists. Customers play and model there, and spend lots of money. The games and the lore are promoted in Warhammer books, magazines and websites. It is a highly-specialised business dedicated to selling more models. But it is also a designer, manufacturer, retailer and publisher. It licenses Warhammer stories and characters to video-games companies and is scripting a TV series. Building a business to rival the capabilities of Games Workshop would be difficult enough even if the original did not already exist.

Churchill's sturdy leadership

Last September Churchill China bought out the co-owners of its clay supplier, an event that barely troubled the stockmarket, but was a significant move to shore-up the potter's competitive advantage. The processes Churchill has developed over centuries to manufacture plates, bowls, cups and saucers are determined by the type of clay it uses, which is different to European competitors' clay. The difference makes for tougher plates that are relatively cheap to make. These qualities are prized by customers in the hospitality industry because of the quantity of tableware they buy and the bashing it gets in commercial kitchens.

Putting people first

The best businesses to buy and hold are customer-focused because satisfied customers return time and time again. Howden Joinery has found a way of generating repeat sales of fitted kitchens by focusing on small builders, who fit kitchens frequently, rather than homeowners, who purchase kitchens infrequently. Its primary goal is to make life easier for the builder. Of course it designs kitchens the builders' customers like, but it also makes sure they are easy to fit, keeps everything in stock so builders are not delayed if they need components, gives the builders a confidential discount and provides them enough credit to finance the job until they receive payment. Howdens must pay for these customer-friendly policies, but they are more cost effective than employing its own sales force and installation teams as many of its competitors do.

Then there's power-converter supplier XP Power. Its products include industrial versions of the AC/DC power adapters used in electrical goods and converters that control the ebb and flow of DC power in industrial equipment. The group moved into manufacturing a decade ago, but as a distributor with sales offices already serving the major manufacturers of industrial and healthcare equipment, it started with a big advantage. Its technical sales force knew the increasingly demanding requirements of its customers, particularly in terms of reliability and energy efficiency. It can take up to two years to design a power convertor into a machine, so XP Power does everything it can to make this easier by designing families of devices it can slot in with minimal customisation and working with customers as they design machines. Many machines require multiple converters, and most manufacturers make many machines, so cosying up to customers has proved a canny way to gain a larger share of their business.

Skin in the game

The average tenure of CEOs at large British firms is about five years, scant time to introduce and entrench a winning culture. Instead, many bosses behave tactically, encouraged by hefty bonuses and misnamed long-term incentive plans. This can lead to decisions that lift profit in the short term, but destroy value in the long term, such as overzealous cost-cutting or expensive acquisitions. A winning culture requires consistent leadership to take hold. This can occur because a company promotes from within, or because a founder or descendents of the founder retain large shareholdings and stay involved in the business. Because of their personal investment they often have one eye on leaving a legacy. As major shareholders, they tend to be more interested in growing the business sustainably than lining their pockets immediately.

After decades in charge, the founders of Howden Joinery and Victrex retired recently. This is often a worrying moment for buy-and-hold investors, but there are no signs of cultural upheaval at the two companies. Dart's charismatic founder, former stunt pilot Philip Meeson, still runs the business 36 years after buying an outfit that flew flowers from the Channel Islands and distributed them in the UK. But the prize for long service goes to the Goodwin family. Goodwin manufactures massive steel castings on a scale few other companies can match worldwide and also supplies the jewellery casting industry. Earlier this year the sixth generation of the family took over.

The five favourites

All of the stocks bar Alumasc retain my confidence because they have so many of these qualities (Trifast, a maker of nuts, bolts, rivets and screws, and defence technology group Cohort are the final two on my list). Alumasc supplies premium building materials. It is specialised to a degree, focusing on products such as roofs, gutters, downpipes, drains and solar shading for the outside of buildings. It has also been under the same management for a long time, but the company has been unable to convert high levels of profitability into growth despite reconfiguring to focus on the building envelope. It is diverting about half of its cash surplus each year into a defined-benefit pension fund that is many times the size of the business and severely in deficit. While Alumasc may flourish one day when it has shorn itself of the pension burden and resolved problems at its loss-making solar-shading subsidiary, for now it is a turnaround play rather than a buy-and-hold investment.

Weighing up the qualities and valuations of businesses is a subjective exercise. The longer the duration of the investment, the less important the purchase price because compounding returns from a growing business should outweigh all but the most egregiously expensive initial valuation. Still, high prices dent returns so buy-and-hold investors should try not to overpay. I think the five most attractive buy-and-hold stocks at current valuations are XP Power (LSE: XPP), Victrex (LSE: VCT), Howden Joinery (LSE: HWDN), Dart (Aim: DTG) and Goodwin (LSE: GDWN).