Is It Time To Let Go?

By Daniel Kadlec

As an investing strategy, buy and hold has never been more suspect. Giant companies now collapse in scandal, like Enron; fall woefully behind in technology, like Polaroid; succumb to litigation, like Halliburton (asbestos); or get whacked by overpriced deals, like AOL. Are there still stocks that you can throw in a drawer and sleep well for years? Or has investing got so hopelessly complicated that individuals shouldn't try to go it alone?

TIME senior writer Daniel Kadlec questions five pros: Ron Baron, manager of Baron Asset Fund; Eleanor Blayney, a financial planner at Sullivan Bruyette Speros & Blayney; Eric McKissack, a manager at Ariel Mutual Funds; Gary Pilgrim, president of PBHG Funds; and Gus Sauter, manager of the Vanguard 500 Index fund. Our panelists agree that diversified mutual funds are best for those with little penchant for serious stock research. For investors who want to buy individual stocks and are willing to do some homework, our pros offer tips on what to hold--and when to fold.

TIME: Greedy, deceitful managers like those at Enron pose a risk for buy-and-hold investors. How do you defend against dishonesty?

PILGRIM: The kind of problems we're talking about with Enron--at large companies--is a fairly recent development. But routine efforts to stretch the financial truth, particularly among small companies, have been going on for a long time. It gets down to basic honesty and integrity. Some managements have a strong sense of that, and others don't. Combine that with a flexible moral framework with stock options, and over a period of time the focus has increasingly shifted to how rich can you get, how fast? The ploy is to keep expectations rising. But at some point the business won't support the expectations, and that's when the cheating starts.

TIME: The spread of this behavior to large companies really undermines the buy-and-hold philosophy, since these are just the companies investors believe are safe.

PILGRIM: I agree. It has trickled up and become more complex.

SAUTER: The other thing that's been going on for years is managing earnings quarter to quarter to make it seem as though business is on a nice, smooth, upward slope.

TIME: But managed earnings can be good, right? At least people thought that way about General Electric for decades.

BARON: I don't think it's a good thing. That's not the way business works in the real world, and anyone who reports earnings at a predictable pace every single quarter, every single year is probably using practices that are questionable.

TIME: Would you stay away from GE for that reason?

BARON: Yes.

TIME: Eleanor, what do you tell clients about managing company stock and stock options to stay away from a disaster like the one that befell Enron employees?

BLAYNEY: Long before Enron came along, we were arm wrestling clients to divest, first in their 401(k), then on their options. That's a constant challenge as a planner, to get them to unload their company stock. They believe in it.

TIME: Options are tricky. You don't want to exercise and sell the minute you have a 2-point gain. What's the right formula?

BLAYNEY: Generally, options are leveraged so they're better to be held, but there comes a point where you have to be prudently diversifying rather than running them to the last day in the holding period.

TIME: So you urge people to average out, to sell in regular increments?

BLAYNEY: Yes.

TIME: Are we at a point when individuals should just concede they don't have the time it takes to research stocks and should stick with mutual funds?

BLAYNEY: Not necessarily. We may be overlooking the obvious: How do you encapsulate an Enron? That's a company-specific risk, and without spending more time, you offset that kind of risk through diversification. I'm not going to pore through vast disclosures. I'm going back to basic advice.

SAUTER: If they are going to invest in stocks themselves, it's got to be a really strong avocation. Three-quarters of all professionals underperform their benchmark. It's hard to believe individuals are going to outmaneuver professionals.

TIME: Another risk is companies, like Kodak, where technology overtakes them.

PILGRIM: The nifty fifty [big stocks that were popular in the 1960s and '70s] are still dying, one at a time.

TIME: That's right. How do you know when the growth story is over?

PILGRIM: Pay attention to how sales and earnings are doing. If a company goes into a steady decline, like Kodak or Polaroid, you'll have many opportunities to observe that things are changing. Yes, there are bombshells when you wake up and your stock is down 40%. But there are many more cases of companies whose growth characteristics gradually begin to change. I don't think individuals have any business buying stocks. They don't know how to diversify; they don't know how to follow them. I think they should adopt a buy-and-hold strategy for a group of mutual funds and spend the rest of the time trying to improve themselves on their job.

TIME: Would you have said that 15 years ago: Don't buy individual stocks?

PILGRIM: Probably not, but that's more a reflection of my experience than that anything's changed. It's very hard to pick stocks, because companies' fortunes are constantly changing. How many stocks does it take to diversify that away? You might as well index.

MCKISSACK: I still think there's room for the hobbyist investor.

BLAYNEY: What's important is a sell discipline. When you would no longer buy a stock, you should sell it. People aren't good at that.

BARON: We own stocks 10 or 12 years. We're investing in companies that I think are going to double in four or five years, then double again, then double again. When do we sell? When we believe the stock won't double in four or five years--usually when we see their competitive advantages diminish.

MCKISSACK: When we initiate positions, we set a price target. We're willing to hold stocks for many years. But our price targets are always moving, based on changing fundamentals, and we'll sell when they reach those targets. That's consistent with the buy-and-hold strategy, which doesn't mean hold your entire life but enough years to allow the opportunity to evolve.

TIME: Are corporate failure rates rising?

PILGRIM: Certainly, at this point in the cycle, yes. As a secular matter, in the technology area it seems like it's getting more difficult for a company of any sort, size or shape to maintain an advantage for long.

TIME: Ron, as a buy-and-hold guy, do you even look at tech?

BARON: No.

TIME: Eric?

MCKISSACK: Almost not at all.

TIME: O.K., so if you find a small company that's growing, buy it and hold. But when people talk about buying a few stocks and throwing them in a drawer, they're thinking about GE and IBM, blue chips that have proved themselves. And yet those are precisely the firms that may be most at risk: from technology, from litigation from things like asbestos and other challenges.

SAUTER: I think you should buy and hold, but not just the blue chips. Be diversified. There's a great argument for buying and holding the entire market forever, and that's really the argument for indexing.

TIME: But in a down market, like now, indexing doesn't work, does it?

SAUTER: By definition, if the market's going down, the index fund will go down with it, so with an actively managed fund you have a chance of a positive return. But it's an unlikely event.

BARON: With the tremendous growth in index funds, it's easier for active managers to outperform. Indexing homogenizes. The good companies and bad companies get the same P/E ratio. The investor who sees things that others don't has an opportunity, because everything is being valued the same way.

TIME: How should we go about buying and holding?

BLAYNEY: We believe in creating a core part of the portfolio using index funds and using exchange-traded funds and some actively managed funds around the edges. We've used the Dodge & Cox funds on the value side; we've used Hartford Capital Appreciation on the growth side; we've used Baron Asset on the small-growing-into-midcap side.

TIME: When do you jettison an active manager?

BLAYNEY: We consider it a red flag when we see a change in the management, and we don't look kindly on style drift. If we're buying a manager, we want him to operate in his zone.

TIME: Give us a few names we can buy and hold.

BARON: One is ChoicePoint, a database company. They know more about Americans than anyone. All the insurance companies give them data about you as a driver, a homeowner. When you want to switch your policy from State Farm to Geico, Geico has to know that you haven't just killed 10 people with your car crashing into a bus, so they pull this database, and ChoicePoint charges them. We've owned it for three years, but I've recently bought more. No. 2, Apollo Education. We've been investors for four years. Apollo is in adult education, and its core business is in teaching adults one course at a time instead of a whole curriculum. Enrollment has been growing 15% a year. We also like Polo Ralph Lauren. People view it as an apparel company, but we think of it as a branded lifestyle company. They're selling at the lower multiple of an apparel company.

PILGRIM: Here are five technology picks, on the hunch that many things will get better: Documentum, JDA Software, Mercury Interactive, QLogic and Microchip Technology. They're the dominant factor in everything they do. They're the quality in a busted-up sector. Away from tech, we like Bed Bath & Beyond. It has lots of years to grow. Starbucks--they're going to open three or four times as many stores over the next decade.

MCKISSACK: A stock like MBNA, the credit card issuer, we've owned for a long time. It's growing from what was a midcap company into the larger-cap space. It has demonstrated 20%-a-year growth and, with its credit review and issuance process, it has an above-average customer in terms of income and payment history. We've also been very successful with SunGard Data Systems and continue to see that as a good long-term opportunity. It provides specialized software into the financial-services market and recently bought Comdisco to make it a larger player in that area. Comdisco was one of the companies to help businesses get back up quickly following 9/11. In the consumer area we like Clorox. It owns Kingsford charcoal and Hidden Valley, interesting and sustainable franchises. It's not growing at a rapid rate, but it is a very sustainable franchise, and we think that it's an industry that will consolidate over time, though that's not why we own the stock.

TIME: Eleanor, when people tell you they're buy-and-hold investors, you have said you question them to see if they have the constitution for it. That will surprise those who consider buy and hold a conservative strategy.

BLAYNEY: Many people buy and hold because they're afraid of making a decision, so it becomes a form of inertia or paralysis. And that has its own risks, some of which we've talked about here. Being a buy-and-holder demands that you actively look at and buy a stock's story each and every day. That's the kind of exploration we go through with our clients.