Caterpillar Shows Why Buy-And-Hold Is Not Dead

Aug.30.12 | About: Caterpillar Inc. (CAT)

There has been much opinion lately that the buy and hold method of investing is now dead. With computer algorithms, flighty markets, volatile volume levels, and growing interests in bonds causing interest in owning stocks for a long time to wane, "no one" should use buy and hold. That last statement couldn't seem more preposterous when the buy and hold system is looked at, especially in today's times.

If the stock market is looked at over any 20-year period the average historical return the market has yielded has been positive. Let's take a look at a specific security that is well-known and not particularly 'sexy' or 'new' like the most-recent flopped IPOs that will remain nameless. A world-known company that raises earnings and profits each year. Caterpillar (CAT).

Before we get in depth into CAT, I want to make a very important point. No matter what your method of investing, if you don't invest in good companies, you will more often than not get not-good results. Companies that increase earnings, increase profits, and pay dividends (hopefully increasing too) over long periods of time have far outpaced the historical market returns. I'm not just speaking of the famous Dividend Aristocrats, although that's not a bad list to start with; I'm talking about good, solid companies that do the things we'd want to see in order to keep making more money, which would likely then cause their stocks to go up.

Taking a look at CAT's numbers, 2009 was a horrible year. It was horrible for almost every other true manufacturing company; orders and sales were down, and of course earnings and profits were down as well. By taking a look at what's happened since then, it's easy to see that CAT is a steady revenue, profit, and dividend increaser. And their metrics are really good.

Let's say the stock was purchased in late 2008, right about the time that the CAT CEO was saying that things weren't looking good in the economy and that trouble was on the horizon. This time wasn't at the bottom of CAT's price drop during the recession. An investor would have paid around $45 per share for CAT in the last quarter of 2009. I just use that price as a departure point to show general numbers to allow for calculation of return.

Let's say that the holding period was forever, which is the ultimate holding period for buy and hold. If the historical market yearly return is 7% without dividends, and approximately 9% with dividends, a buy and hold investor would be doing well, and beating the average market, if those numbers were exceeded by their securities. Let's now take a look at how that investor of CAT would be doing at this time, and what to expect from the future.

At the time this article was written, CAT is trading for about $87.50. Using a yearly rate of return, and 35 months of time (from October 2009 until August 2012) CAT has returned its investor 32.2% yearly! That's over 4 times the historical return of the market. And, if dividends are included, that return goes to a little over 35%. That's almost 4 times the historical return of the market with dividends reinvested.

Let's take a look at the famous P/E ratio. That ratio is used lots of ways: to determine if a stock is perceived to be 'cheap' or 'expensive' by the market, to determine popularity of a stock when compared to volumes, etc. Stocks typically trade at a 6 to 12 month forward P/E ratio. That is, investors and the market usually price in anticipated earnings into the current price of a stock. Since none of us can predict this, and analysts are forever changing earnings estimates, which can significantly affect the P/E ratio, buy and hold investors can use historical P/E over a LONG period of time to anticipate what a stock's P/E can be expected to do over a future long period.

At the risk of being chastised here, I wish to make a couple of important points: I'm speaking of this anticipation of P/E being done for good companies who have a long track record of doing the right things. Companies that are led by solid, believable management, and companies that are interested in shareholder returns as well as growing their business. Companies built like this will have less likelihood of volatility in earnings, and therefore can be expected (as much as is possible) to follow their historical P/E. Changes in marketplace, management, and other factors could make a good company be not-so-good, at which time most buy and hold investors would likely sell that stock. I'm looking as if the glass is more than half full and the company is continuing to do what it says it will.

CAT has always tried to be a shareholder-friendly company. Other than the time period when it was embroiled in its well-known strike with its workers, the company has delivered on its promises to grow and have good shareholder returns. It is currently trading at a P/E below 10. That is worthy of mention, because if the P/E over the last 20 years (including the strike period) is looked at, the company has traded at a P/E of near 14, and over a period longer than that, according to data that can be gathered from numerous stock listing websites and CAT's website, the stock has traded around a P/E of 17.

If the company is a good company, and isn't embroiled in a problem, and is meeting or exceeding its goals to increase earnings and dividends, then it should be expected to be near its historical long-term P/E now and in the future. If CAT were trading at it's 20-year trailing P/E, it would be a $134 stock assuming it meets it's 2012 consensus earnings of $9.61, as reported by CNBC. That's a huge premium to today's price. Why is CAT down now? The turmoil in Europe and China has caused ripples in our economy every time it surfaces in force. Because CAT is reliant on the US market, and somewhat reliant on Europe, and actually not very reliant on China, this economic turmoil turns off investors to CAT. Look back at the last couple of years as to how CAT has recovered once the storm clouds have thinned: it's gotten back much closer to the P/E of 14 than the P/E of 10.

If the company makes its earnings estimate for 2013 of $10.35 as reported by CNBC.com, it would be a $145 stock at a P/E of 14, but would be a $103.5 stock at a P/E of 10, not much of a stretch from its trading value in today's current market. At the lower P/E, that's a 14% average yearly return from here to the end of 2013! That alone beats the market average return.

At that price, which is clearly depressed from a historical standpoint, the buy and hold investor who bought late in 2008 would have a yearly return of 43%, which has gone UP from today's return! With this return, if the investor held the stock and it's price didn't change, he could hold it until 2019 and it would still beat the stock market's historical return. That isn't recommended, because a stagnant price would likely be due to problems with the company at which time it would be wise for anyone to sell. This just shows the power of holding good companies for a long time.

This investor understands the idea of using algorithms and buying and selling. Also keep in mind that not everyone has the advantage of being in a $6, $7, or $10 per-trade account, so commissions can eat up some of profits when an investor trades a lot. Additionally, if a trader trades a lot, that trader has to be right more times: each time they buy and sell, traders have an opportunity to be wrong, and lose money. The buy and hold trader gets two chances: at the initial purchase, and the sale. Not trading the dips and peaks eliminates a chance to lose money and minimized commission costs. Sure, there could be more profits, but why take the chance and risk it since you're investing in a good company? The long term price curve for good companies like CAT goes up as long as the metrics point in that direction.

Buy and hold is alive and well. The key is to invest in good companies, that increase their earnings and profits. Hopefully those companies pay a dividend, and an increasing one at that. The time period has to be long enough to smooth out the peaks and valleys, but if patience is used, knowing that bad and good economic times on the company, national, and world level come and go, a buy and hold investor can make some significant gains, beat the market, and sleep at night knowing that they have set themselves up for a better financial future.

Disclosure: I am long CAT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.