The Death of Buy and Hold Is Greatly Exaggerated (Part 2)

In Part 1 of this series, I focused on the validity of buy and hold from the perspective of when to properly buy. The central idea was that buy and hold will only work if you buy the right investment and pay the right price.

In Part 2, I introduce the concept of when to sell. The central idea here is always buy at sound value, but do not mindlessly hold.

There are two primary characteristics that can and will destroy a successful buy and hold policy. The first and most obvious to determine is overvaluation. The Fundamentals-at-a-Glance research tool we developed make this straightforward and rather simple to do. Massive overvaluation is an obvious mistake that can and should be avoided.

In Figure 1, we show Oracle Corp. (ORCL) over the period 1993-1999. As you can see, Oracle Corp. was nicely in value in the beginning and became excessively overvalued in the end with a PE ratio of 92.8. It should be clear that to continue holding Oracle Corp. at such an extreme value was dangerous if not reckless behavior.

FIGURE 1 ORCL 1993-1999 earnings-price correlation

In Figure 2, you will witness that even though Oracle Corp. rose from its year-end 1999 close of $28.02 to a peak of $46.47 in September of 2002, it inevitably fell to its earnings justified value of $13.81 by year’s end. Holding when Oracle Corp.’s stock price was above its earnings justified level made no economic sense at all.

Figure 2 ORCL 1993-2001 earnings-price correlation

Figure 3 summarizes the principle of when a buy and hold approach makes sense and when it makes sense to sell instead.

FIGURE 3 ORCL 15 year earnings-price correlation

Figure 4 shows that buying and holding Oracle Corp. over this 15-year period was a very good investment. However, if we refer back to Figure 3, it’s obvious that selling Oracle Corp. in 1999 or 2000 and then buying it back when it returned to value made more sense.

FIGURE 4 ORCL 15 year price performance

Admittedly, Oracle Corp. was an extreme example in 1999-2000. However, the principle is sound. Overvaluation can be rationally calculated and the appropriate sell discipline can be executed when fundamental valuation is intelligently considered.

The second characteristic is a deterioration of fundamentals. Figures 5 and 6 show that Bank of America (BAC) was a great buy and hold for the 14-year period 1993-2006.

FIGURE 5 BAC 14 year (1993–2006) earnings-price correlation

FIGURE 6 BAC 14 year (1993–2006) price performance

However, Figures 7 and 8 vividly illustrate how deteriorating earnings will destroy a buy and hold strategy. Although trickier to recognize than overvaluation, a diligent investor can effectively avoid this mistake as well.

FIGURE 7 BAC 14 year (1996–2009) earnings-price correlation

FIGURE 8 BAC 14 year (1996–2009) price performance

At the end of the day when all is said and done, buy and hold is a very intelligent and attractive way to invest money. On the other hand, it must be executed with discernment. Thinking about buy and hold in general terms is a great disservice to its many benefits. However, with the recession driving prices of many of America's best companies to extremely undervalued levels this is a great time to invest in the best. Buy and hold is alive and well and always will be.

Full disclosure: Long ORCL at the time of writing.

Comments

[twotraps:]

Interesting article and I agree with the your idea that buy and hold has a place in investing. Too often "buy and hold" competes with 'not' buying and holding...or all the other trading craziness, and general willy nilly buying and selling usually with quite poor timing leading to uneven or negative results!! Also, I assume that when you discuss 'buying at a good price' , there is some strategy you apply consistently in order to filter which stocks to buy. On that note........ I do have an issue with the majority of brokerage firms luring the public into buying and holding beacuse 'over time....stocks always rise.' WOW. That is a problem. Sure, this last 18 month sequence is not likely to disturb the 75 yr average that stocks do well over time, but it sure hurts in the meantime. The turtle traders made a bit of cash buying and holding...but they had a plan of when and how much to buy, and when and how much to exit/sell. They were willing to capture the trend but not fall on the sword for it. Its a bit off topic but buying and holding Merrill Lynch when management was not about to reveal its subprime exposure may have left you adding to losers all the way down.

Jul 10 09:06 AM

[Mad Hedge F...:]

In the long term we are all dead. CNBC held a dynamite interview with David Rosenberg, former Merrill Lynch chief economist and current strategist at Gluskin Sheff, who offered the kind of big picture, 30,000 foot view that I love. We are well into an epic post bubble credit collapse. Deleveraging in the private sector is dramatically overwhelming any fiscal stimulus Obama can throw at it. The $50 trillion US household balance sheet is shrinking at an unprecedented rate. The unemployment rate will easily sail through 10.8% to a new high and spill over to a higher foreclosure rate. We’ve had two decades of baby boomers living beyond their means, and it is now time to revert to the mean. The stock market has already priced in an earnings recovery which we won’t see until 2012 at the earliest. Bull markets move in perfect 18 year cycles, and we are only half way through a generational washout in equity ownership that started in 2000. “Buy and Hold” is dead. An S&P 500 trading around a 13 multiple means will be stuck in a 650-950 range for years, and that’s being generous. Rent, don’t own stocks. The one place to be is commodities, because they will be underpinned by the undeniable demand coming from Asia, and have benefited greatly from consolidation. The big “Tell” here is that in last year’s huge sell off , they all bottomed at the previous cycle’s peak prices. It’s nice to hear someone reading from the same sheet of music as I. Too bad Merrill Lynch didn’t listen to David. Wow, do you think I should be selling rallies here at 886?

Jul 10 10:19 AM

[Pat Shuff:]

Summers then shifted in that March speech to discuss how the potential for growth was substantial:

“Earlier this week, the Dow Jones Industrial Average, adjusting for inflation according to the standard Consumer Price Index, was at the same level as it was in 1966…”

www.ritholtz.com/blog/.../

Something that hasn't twitched in 30 yrs could safely be presumed dead. Maybe try poking it with a stick if the smell isn't too strong.

Jul 10 11:17 AM

[BigOlDave:]

It's incomprehensible that anyone considers "Buy & Hold" a viable strategy.

It's neither.

You know, a lady I knew (now long dead) bought stock in strange little companies. Her wealthy husband thought she was nuts, but loved her and knew he couldn't change her mind about anything, so he gave her money to "play" with: a little bit at first, then -- after these little companies started doing tremendous business and their stock prices surged -- he draped gobs of free cash, even selling some of his old dogs and letting her invest.

They retired wealthier than he deserved. She turned her account over to her broker, and they retired. During the next 20 years, business went global, their investments withered, she died, he went senile, and he refused all brokerage advise.

He held ...and held ...and held. First her textile stock went bankrupt, then the steel services company merged and he got skinned, and the rest of his investments got shifted into a mutual fund at his son's urging.

Then the son died. The woman's daughter-in-law slavishly hangs onto her withering mutual fund because it "keeps up with the market pretty well."

If your objective is to "keep up with the market pretty well", stop reading Seeking Alpha and other thoughtful sources, put your money into an INDEXED mutual fund, and go volunteer at a charity someplace. Vanguard pumps these products because they manage them for the lowest fee around. But a bad strategy for a low price is ...

...still a BAD STRATEGY!

Buy-and-hold has even been forsaken by entertainers like Jim Cramer. The new version is "buy-and-homework". Better yet, "Do homework / Buy Low / Do homework / Sell just as soon as things start turning bad or when there's a faster train on the tracks / Do homework." This strategy is guaranteed to outperform the market and, over the intermediate term, make you money.

It's working for me! And that's in the worst stock market environment since that long-dead, wealthy lady first started investing.

Dave

Jul 11 10:12 PM

[BeachRider:]

Mr. Bigoldave,
I have soured on Index fund and am snakebit on Mutual Funds, in general. My trust in the management of these funds has dropped significantly because they rode the slides so-far-down. At least 40% of mutual funds underperformed the S&P500 dramatically! There is no excuse for that happening. Right now, my employer is offering a T-bill plan alongside the Fidelity and other stuff. Stocks could certainly go down, but the funds have gone down even more.
I suppose that I am buy-and-hold, but with a sell-level, until I see where better managed-financial opportunities arise.

Jul 13 08:18 AM