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'Buy and hold' or 'momentum': Which is better? In a word: neither.

To quote an ad campaign that fell rather short of the mark, “This isn’t your father’s Oldsmobile any more.” When I made my first stock purchase back in 1968, it was all about finding quality companies that regularly increased their sales and earnings. Extra kudos went to those that could, by exercising the very best operating controls, increase their earnings even faster than they increased their sales. In those days, when individual investors were as important a factor as institutions and when institutions actually bought and held themselves, if you were patient and bought the right companies you would always come out ahead.

Then came government bailouts of big banks and brokers after their idiotic forays into Latin American sovereign debt, then the blurring of lines between banks, brokerages and investment banks, and finally the most recent bailouts and guttings of investor protections that have only made the big Bigger and the arrogant More Arrogant. So does that mean that because these behemoths trade in milliseconds, long-term for individual investors should also be close of trading every day? That we should jump aboard only the trains that are already moving and hope to enjoy their acceleration before wildly jumping off before they smack into a wall?

No. That isn’t investing and the lies Wall Street provides like “Frequent trading in large blocks provides essential liquidity to the marketplace” only disguise their horrendous failure to manage their businesses creatively and well, leaving their trading desks flash-crashing, hyping, and scalping as their only source of dependable income. Pathetic.

I believe there is a middle way. We still research the companies we buy for our clients scrupulously, would like to hold them as long as we can, and do hold them as long as it makes sense to do so. But we also recognize that the markets are today far more volatile than in the past and we must be willing to employ trailing stops, take some profits along the way, write covered calls to reduce our cost bases, and occasionally even purchase (non-leveraged) inverse mutual funds or ETFs or short their long-side cousins in order to keep the quality companies we want to buy and hold without seeing our net worth decline during pullbacks.

In my business, wealth and risk management, I am regularly besieged by some clients who are convinced we are all headed for financial Armageddon asking why we are not 100% in cash and, the same day, by others who insist this is the opportunity of a lifetime and annoyed that we are not 100% long. I recently described this investor conundrum in our monthly Investors Edge ® as a “Tale of Two Client Gardens.”

I wrote it as a result of having two new clients join us. They could not have been more different in the existing portfolios they brought to us, their outlook for the markets, or the way in which they viewed the likelihood of building their portfolios for future gains.

The first new client had created a well-ordered portfolio designed to take maximum advantage of a strong bull market. His portfolio is comprised of long ETFs covering a number of different market capitalizations, asset classes, and sectors and industries. There are common stocks that would clearly enjoy a positive outlook as long as the economy and stock markets move forward. And there was virtually no cash cushion, because staying fully invested meant to this client being assured the maximum return every day. It was buy-and-hold, but took advantage of the momentum in the market itself. In short, this was a great portfolio for the half-year we have just experienced.

The second client, on the other hand, brought us a portfolio that, at first sight, was a real mishmash. There were vestiges of busted companies that trade for pennies, stocks in a number of different sectors that may or may not have been purchased as part of a plan, and more than a few inverse ETFs that may be counted upon to cut into the profits obtained from the long positions. This client also didn’t mind keeping a bit of a cash cushion available; a little dry powder, if you will, to be able to use in case he found or, now, we find, exceptional bargains selling for less than we believe they should.

Logically, most would leap to the conclusion that Investor # 1 was positioned the best for the coming half-year as well. After all, what is there on the horizon to change the market’s direction? It’s already successfully climbed a wall of worry that includes a too-sluggish recovery from a serious recession, possible sovereign bankruptcies in Europe, a US budget that makes us the largest debtor nation in the world, 10% unemployment, and conflagrations in the Middle East.

I, on the other hand, reach a very different conclusion. Let me say why -- by thinking of these two portfolios as two neighboring gardens. Investor # 1 has chosen to plant all of his well-ordered, well-considered flowers in the sunniest place in the garden. This makes some sense, in gardening, in that typically the most colorful flowers grow in sunshine and sunshine creates the most robust growth. The problem is twofold: sometimes too much sunshine also carries with it heat which causes wilting and destruction. And sometimes the dearth of sunshine for an extended period means the death of flowers too dependent upon continued growth.

Of course, given how colorful they are and how good their growth has been, you keep them even as they are wilting hoping they will come back. Pruning may have been the more expeditious choice, but it's hard to prune the things you love. Certain species of flower will fall prey to overheating faster than others. But you keep them anyway. And all of them which thrive only in full sunshine will fail as a group when the sun hides behind the clouds and summer thunderstorms last for days on end.

Investor # 2, on the other hand, has a more typical garden. Sure, he contends with more weeds than Investor # 1. Those have to be worked out of the ground (or the portfolio) with a bit more frequency and discarded as just not pretty enough to hold onto -- or as creating problems for the garden overall. In addition, Investor # 2 has some flowers that simply don't look as good as his neighbor’s flowers, at least not as long as the sun is shining and the future looks bright. He has some less colorful foliage and some less stellar flowers that he grows in the partial shade and shady places on his property, though, knowing that if the sun doesn't shine for a few days, he'll still have at least some cut flowers and greens coming into the house.

In fairness, there is no telling which investor will do best in the coming growing season because no one knows precisely what the weather will be. If we get many days of mild sunshine, not too hot and not too cold, that continue for the entire season, Investor # 1 will be most amply rewarded for his optimistic /aggressive / some might even say cavalier approach to gardening. But if the sun don't shine, or the rains are too hard, or a late-season hailstorm cuts down some of the best specimens, then Investor # 2 will be the one who can re-seed, re-plant, and cull specimens from more protected areas. His willingness to keep some seed corn back, to plant in different areas, and to be willing to accept that not all days will be sunny will keep his garden growing.

I understand that if you see lilacs the two or three weeks a year they are in bloom, you might be ready to rush right out and fill your entire yard with lilacs. But I've also been gardening this plot long enough to know that wishin’ don't make it so. I know there are good seasons and bad, seasons of light and seasons of darkness, springs filled with hope and winters which some despair will never end.

I know I would be far more successful at attracting capital if I had it in me to tell potential clients that winter was no more; that every day of the entire year was going to be sunny and bright. That kind of optimism may be infectious, but it's also ludicrous. That’s why I try to blend the analysis that leads to buy-and-hold with the willingness to protect gains / control risk that momentum investors enjoy on their best days.

I am rock-solid certain that as long as entrepreneurial capitalism survives on earth, the stock markets that are the ultimate arbiters of entrepreneurial success will surge forward, consolidate, surge again, correct, surge again, tumble, and surge again. I am a cockeyed optimist on the future. However, I realize that sometimes we put our powder in the shed to keep it dry and sometimes we sprinkle it about.

The joy of relative momentum is that, since stocks rise about two thirds of the time and only fall about a third of the time, you make money by hopping aboard the fast-moving train when it is going the greatest distance. The despair of relative momentum is that during that one third of the time that the market falls, it falls at roughly twice the velocity of a rising market.

Unlike my momentum cousins in the business, however, I believe the time to become fully invested is before the train leaves the station. This approach has manifold advantages to us as investors. We get to buy during periods when others aren’t bidding the share price of our intended purchases up daily. In fact, we buy them mostly on down days. We have the luxury of doing deep research, then continuing to challenge our conclusions. Nothing is running away from us, so we don’t buy in a panic without knowing what it is we are really buying. We don’t even try to buy at “the bottom” or sell at “the top.” We accumulate at lower prices and distribute, hopefully, at higher prices.

If you want some ideas for what I believe are great companies in great sectors, which may or may not track the market this week, this month, or even for the next few months, but which over time we’ll bet our history in the business might do very well for you, I encourage you to review the suggestions for your own due diligence that I have provided in recent articles such as Cameco (CCJ,) Cenovus CVE,) Denison Mines (DNN,) Encana (ECA,) Imperial Oil (IMO,) Mosaic (MOS,) Rubicon Minerals (RBY,) and Teck Resources (TCK.) You may find more on these fine firms I’d like to buy-and-hold here.

Or you might consider Waste Management (NYSE:WM) or Sims Metal Management (SMS) or Lynas Corp (OTCPK:LYSCF) discussed, respectively, here and here.

Finally, if you like the idea of holding longer-term but protecting the net asset value of the portfolio, you might want to consider these two inverse hedges which we see as over-valued: ProShares Short S&P 500 ETF (NYSEARCA:SH) and ProShares Short Russell 2000 ETF (NYSEARCA:RWM). ) We believe the small caps of the Russell 2000 have had the biggest run and got the furthest away from their respective 200-day moving averages. Our further logic is here.

In our portfolios we have some flowers we've grown from seed, some we purchased as plants, and some bulbs which won’t flower for awhile; some shade-loving vafrieties and some sun-lovers; some that like wet feet, some that don’t. We think the garden looks best with a combination of all.

Disclosure: We, and/or those clients for whom it is appropriate, are long all of the securities mentioned in this article: CCJ, CVE, [DNN]], ECA, IMO, MOS, RBY, TCK, WM, SMS, OTCQX:LYSDY, SH, RWM.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we “eat our own cooking,” but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Source: Buy & Hold or Momentum? Why Neither Is Better