The Death of Buy and Hold Is Greatly Exaggerated (Part 1)

The recession and trough stock valuations have incited a plethora of discussions and articles on whether buy and hold is a viable investing practice. You cannot argue the merits of a strategy like buy and hold in general terms. This traditional strategy can only be fairly and accurately evaluated as it applies specifically. Therefore, the only rational answer to the question on whether to buy and hold or not is - it depends.

Under certain circumstances buy and hold is a powerfully profitable and brilliant approach. However, it can also be an unmitigated disaster. As Kenny Rogers so aptly put it in song; “You got to know when to hold ‘em, know when to fold ‘em, know when to walk away and know when to run.” In the next stanza of “The Gambler” Kenny offers additional insights into buyin and holdin. “Now every gambler knows that the secret to survivin is knowin what to throw away and knowing what to keep, cause every hands a winner and every hands a loser.”

Utilizing our Fundamentals-at-a-Glance research tool, I will illustrate the many faces of buy and hold. We will look at when it works great, and why. We will look at when it fails miserably, and why. Most importantly, I will point out ways to know in advance whether buy and hold is the correct policy or not. This will be accomplished by examining the important investing attributes necessary to get it right.

First and foremost, buy and hold works best when investing in strong growth at sound valuations. Figure 1 below offers a 15-year earnings and price correlated chart on Quality Systems, Inc. (QSII), a quintessential example of a right company bought in value and held for the long run. Based on its 28.4% compounded growth rate, Quality Systems, Inc. was in value at the beginning of 1995 and is currently in value.

FIGURE 1 QSII 15 year earnings-price correlation

Figure 2 below shows that buying and holding Quality Systems, Inc. for the 15-year period was a very profitable strategy. The 33.3% compounded rate of return, excluding dividends, trounced the general market (S&P 500). Special dividends paid and a regular dividend established in 2007 sweetens the pot even more.

FIGURE 2 QSII 15 year price performance

Figures 3 & 4, show that buying and holding Eastman Kodak (EK) over the same 15-year period would have been a terrible mistake. Same time period, same economy and general stock market environment produced entirely different results. You don’t buy and hold companies with deteriorating earnings (blue shaded area, Figure 3).

FIGURE 3 EK 15 year earnings-price correlation

Figure 4 shows that you would have lost almost 95% of your initial investment, excluding dividends, by buying and holding Eastman Kodak.

FIGURE 4 EK 15 year price performance

In the following segment, I introduce the importance of the growth rate, or what I call the rate of change of earnings growth to determine whether "buy and hold" makes sense as a strategy. Figure 5 looks at Consolidated Edison, Inc. (ED), a slow-growing utility over the period 1993-2007. I stopped at 2007 to eliminate recession bias and chose a 15-year period where Consolidated Edison, Inc. started and ended in value, based on earnings. The turquoise area shows dividends paid out of earnings.

FIGURE 5 ED 15 year (1993-2007) earnings-price correlation

Figure 6 shows that appreciation of 2.7% closely correlates to Consolidated Edison, Inc.’s 2.4% earnings growth. With such slow growth, Consolidated Edison, Inc. only makes sense to buy and hold for its slow-growing dividend.

FIGURE 6 ED 15 year (1993-2007) price performance

Figure 7 shows Procter & Gamble (PG) over the same time frame 1993-2007. Procter & Gamble also starts in value and ends in value.

FIGURE 7 PG 15 year (1993-2007) earnings-price correlation

Figure 8 shows that Procter & Gamble’s strong 11.5% earnings growth generated a closely comparable 12% shareholder return, excluding dividends. Note that Procter & Gamble’s faster growing earnings generated $75,912.26 worth of dividends versus Consolidated Edison, Inc.’s $99,367.30. Procter & Gamble’s faster earnings growth rate partially compensated shareholders for its lower starting yield.

FIGURE 8 PG 15 year (1993-2007) price performance

The final segment of Part 1: The Death of Buy and Hold is Greatly Exaggerated introduces the importance of valuation to a successful buy and hold strategy. Here we will compare two well-known retailers over the same time period, with almost identical operating growth rates. The big difference is valuation at the beginning of the time period; Wal-Mart (WMT) is over-valued and Ross Stores (ROST) is in value. Figure 9 shows Wal-Mart growing 11.6% with an overvalued starting PE ratio of 49, more than 4 times its earnings growth rate.

FIGURE 9 WMT 10 year earnings-price correlation

Figure 10 shows that Wal-Mart shareholders lost a compounded (-3.8%) or over 30% of their initial investment due to overvaluation, even though Wal-Mart’s business did well.

FIGURE 10 WMT 10 year price performance

Figure 11 shows Ross Stores, Inc. a smaller competitor to Wal-Mart with a very similar growth rate of 11.9% versus Wal-Mart’s 11.6%. However, Ross Stores, Inc. was trading at a starting PE ratio of 11, approximating its growth rate, when purchased on 12/31/1999.

FIGURE 11 ROST 10 year earnings-price correlation

Figure 12 shows that Ross Stores, Inc. shareholders earned an exceptional 16.6% return, better than either Wal-Mart or the S&P 500 through the same economy and time period. Investing when in value made all the difference.

FIGURE 12 ROST10 year price performance

Clearly, a buy and hold strategy produces significantly different results over various circumstances. Under the right situation, buy and hold is a sound and prudent practice that can be very profitable. Under other circumstances, it can be disastrous. However, properly applied, buy and hold is a superior tactic on the basis of the following principle: A portfolio is like a bar of soap, the more you handle it, the smaller it gets.

Full Disclosure: Long QSII, PG at time of writing.

Comments

[toobad41:]

Interesting view of buy and hold strategy. However, there should be a "know when to buy them" strategy as well. Four of the six companies you mentioned are old and stodgy. Even ROST and QSII are getting that way. IMO those companies are no longer a buy and hold strategy. I hope in your future articles on this subject you will address the "know when to buy them" issue.

Jul 10 08:58 AM

[AndrewBaker:]

"Buy and hold" is just a shortening of "Buy and hold as long as the stock/security/asset gives the required returns." No-one should own investments and not review them regularly, pitching out the losers when doing so.

Jul 10 09:10 AM

[Chuck Carne...:]

I agree with your "know when to buy comment",however,this article was written to point out that general statements about buy and hold are not relavent. My views on when to buy are based on my position as an investor in the business not the stock.Therefore,all my decisions on buying and or selling are founded on the cash(profits) that I expect the business to generate relevant to my return objectives and the risk I am willing to assume to get them. I.E.,I don't try to predict price movements.

I have written articles on individual companies that I thought were buys that would provide insight into my buy strategy.Generally,I buy when I believe long-term value is present based on dfc to present value.Notice that my graphs use a PEG ratio formula for growth above 15% and a Graham/Dodd formula for higher quality slower growth like PG.

Thanks for the comment.


On Jul 10 08:58 AM toobad41 wrote:

> Interesting view of buy and hold strategy. However, there should
> be a "know when to buy them" strategy as well. Four of the six companies
> you mentioned are old and stodgy. Even ROST and QSII are getting
> that way. IMO those companies are no longer a buy and hold strategy.
> I hope in your future articles on this subject you will address the
> "know when to buy them" issue.

Jul 10 09:57 AM

[Dave Shafer:]

Not to belabor the obvious, but what you are describing is a value investing strategy, Graham/Buffett style. I agree that it is a great strategy and practice it myself. However, the buy-and-hold strategy commonly suggested by financial advisers is very different. It suggests that you dollar-cost-average into several different classes of mutual funds and asset allocate to fixed percentages [or flowing percentages based on age] every year. It totally ignores price. Despite the popularity of this strategy it has been dead [your term] as a functioning strategy since 2000 ended the great bull run.

Jul 10 11:20 AM

[Edward Ulys...:]

Buy-and-hold is an excellent strategy. I bought physical gold and silver in 2005 and held. When folks start keeping their promises again, buy-and-hold will be good for certain stocks and time to trade in the gold and silver.. It's a little like sailing into the wind. One must tack one way, then come-about and tack the other way. Never directly into the headwind. And if that wind is from a hurricane, best not to be sailing at all. If you see "green shoots" too soon, you may simply be in the eye of the financial hurricane.

Jul 10 11:49 AM

[Sonia:]

Good article! PEG for the market as a whole is a clear indication of tops and bottoms - time to fold and walk away., or buy quality stocks at bargain prices.

Jul 10 05:47 PM