Last week was a real kick in the teeth for investors and speculators alike. The highlight of this performance was Thursday's action, where a 4% plunge in every major index officially brought us into correction territory. We all saw the headlines. Yahoo! Finance flashing the "breaking news" banner every hour, all the photos circulating the web showing Wall Street traders banging their heads on their desks, media doomsayers left and right predicting a double dip recession. Contrarians like to say buy when there's blood in the streets, but sometimes there's so much slaughter that you're knee deep in the red and gooey and you can't even get to the store.
However, the thing I found most interesting was not the apocalypse, but the day after. It seems that the blow to the head he took on Thursday knocked out some of Mr. Market's marbles and on Friday he just stumbled around dazed and confused. The market couldn't decide if it was bullish or bearish. The Dow see-sawed from down 2% from the open to up more than 1% and stocks swung between the red and black like a pendulum all day. At times like these, buy and hold investors have been taught to sit tight and let Mr. Market have his bipolar mood swings. Trying to predict them is a loser's game, so why bother?
Is Buy and Hold Dead?
But the pain from the last few days was just a pinch in the arm compared to the pain buy and hold investors have had to suck up for the last 10 years. The S&P began the new millennium at 1,498. Last week it closed at 1,199. Ouch. Many have been proclaiming the death of buy and hold, but I believe these rumors to be greatly exaggerated. Skeptics should zoom back their lenses and take a look at the last hundred years, not just the last 10. There have been many periods, sometimes long ones, where the market remained in stasis, but buy and hold always won out in the end for those with the conviction to stick to their guns.
Still, there's no denying that buy and hold has been a tepid strategy over the past decade ... or has it? Buy and hold investors are trained to analyze companies, not stocks. We learn the difference between a stock's intrinsic value and its market value and concern ourselves only with Mr. Market's offers when they allow us to buy good companies at handsome discounts and sell them at hefty premiums. As such, the market value of a stock only matters twice in our relationship with it: during the entry and during the exit.
Between these two end points, however, Mr. Market continually assaults us with his offers and we're trained to tune him out. However, is that the right move? During periods of extreme uncertainty and volatility like these, Mr. Market gets doped up on an extra dose of crazy and sometimes the quotes he puts on the table present highly profitable opportunities for astute investors. By ignoring him, the buy and hold investor is depriving himself of the chance to profit from these opportunities. We're used to taking advantage of Mr. Market's mood swings when we initiate and close out a position, so why not take it one step further and make him our ally during the time in between?
We can do this by evolving the fundamental buy and hold philosophy into a leaner, meaner and more agile strategy: buy, hold and shift.
Buy, Hold and Shift: An Investment Triple Threat
Most of the work involved is exactly the same between the two approaches. We still size up companies from their fundamentals and ignore the technicals. We still look for well managed companies with great financials and wide moats. We still buy these companies at a discount and assemble a portfolio of stocks that we'll be happy to hang on to for the next 10 years. The difference is, with buy-hold-and-shift, we don't keep our capital allocated in the exact same proportions during this entire time. That makes us inflexible and unable to respond to opportunities in the market. Instead, we maintain a portfolio of core holdings that are made up of great companies and we actively move our money around and redistribute our funds between these companies depending on how undervalued or overvalued they become. By selecting good companies, we ensure preservation and long term growth of our capital. By managing our capital with vigilance, we can seize opportunities that present themselves in the market instead of letting them pass us by.
The easiest way to understand buy-hold-and-shift is to think about it like this: instead of buying, holding and then eventually selling, you put together your portfolio and then every so often you return to it and ask yourself, "If I had to start fresh and buy these stocks anew, how much would I buy based on their current valuations?" Then you just redistribute your capital based on your new model.
To illustrate, let's imagine a hypothetical investor named Steve. Steve is a value investor who bases his approach on Benjamin Graham's teachings. After a lot of hard work and due diligence, Steve assembles a portfolio of five great companies that he's snatched up at fantastic prices: Coca Cola (KO), McDonald's (MCD), Apple (AAPL), Procter & Gamble (PG) and Research in Motion (RIMM). Yes, Steve is a member of the endangered species of investors bullish on RIMM, don't hold it against him. At the time he bought them, all of these companies were trading at a discount to their intrinsic value, so Steve bagged some great deals. Steve is confident in the long term prospects of these companies and doesn't believe in speculation, which means that most of his work is finished. All he has to do is sit back and let his investments appreciate in value over the next few years. Life is easy for the buy and hold investor.
One year later, Steve returns to his portfolio for the annual checkup and he discovers that MCD, AAPL and RIMM have all performed in line with the market, while KO has doubled and PG is selling for 20% less than his purchase price. Steve returns to his original investment thesis for these companies, updates it with new developments and comes to the conclusion that Mr. Market has gone from under appreciating KO to smothering it with too much affection. Meanwhile, PG seems to have declined for no reason other than Mr. Market's erratic mood swings. It has been growing earnings quarter after quarter, it's been making a lot of headway in foreign markets and its other fundamentals continue to remain sound. If Steve was a simple buy and hold investor, he would just hang on tight and allow Mr. Market to come to his senses. He always does eventually.
But Steve knows a good deal when he sees one and Mr. Market's irrational fear and greed are presenting him with two great deals right now. He's confident in his judgment that these securities are mispriced. As an amateur value investor, Steve doesn't possess a broad knowledge of all the stocks on the exchange, but the ones he owns in his portfolio he knows like the back of his hand. He is almost certain that Mr. Market is wrong on KO and PG. Rather than sitting out on the bench, Steve decides to capitalize on this opportunity by making a strategic paired trade. He sells out half of his position in KO, which he believes to be overvalued and uses the cash to load up on PG, which he believes to be an even better bargain now than it was a year ago.
This is the only adjustment Steve makes to his portfolio before returning to the sidelines as an observer. After all, he's still a buy and hold investor at heart, he's just re-allocating his capital to places where it can be put to work most effectively given current market conditions. A year after this, Steve returns to discover that time has indeed restored Mr. Market's sensibilities. KO pulled back slightly over the past 12 months and is now fairly priced. PG gained 30% during the same time period and is now also fairly valued. Since neither stock is now mispriced, Steve sells off some of his position in PG to lock in profits and returns that capital to his position in KO to give them both equal weight in his portfolio.
What happened here? By employing a buy-hold-and-shift strategy and actively managing his capital, Steve has made a tidy profit that he otherwise wouldn't have if he just bought and held. The market may very well remain frozen for the next 10 years before it rumbles to life again, but it's almost definitely not going to stay flat during that whole time. By getting in these little nibbles and taking advantage of Mr. Market's volatility, Steve can produce a respectable return over time even if his portfolio doesn't budge as a whole. Buy and hold lets you profit from the long term growth of great businesses. Buy-hold-and-shift allows you to juice up your returns by capitalizing on the inevitable market churn that'll take place many times over your career as an investor.
Becoming a Master of All Styles
Which companies are most suitable for an active capital management strategy like buy-hold-and-shift? You want to look for stocks with high betas that are prone to wild price swings. You want cyclical and countercyclical stocks that move faster and harder than the market on both up and down days. In other words, you want traders' stocks. Contrary to popular belief, traders are actually a value investor's best friends. A stock that is played by a large trader population will be more likely to deviate from its intrinsic value at any point in time and by a larger margin. These deviations are what value investors take advantage of to make money. After all, it's hard to outperform when everything is selling for its intrinsic value exactly. However, you're still a value investor first and foremost, so that means that you don't want stocks with inflated valuations. That rules out companies like Sirius XM (SIRI). Good bets are heavily traded stocks with solid fundamentals and reasonable valuations that wouldn't be out of place in a value investor's portfolio. Companies that fit the bill include names like Microsoft (MSFT), JPMorgan Chase (JPM), Cisco (CSCO), or Intel (INTC).
At his core, a buy-hold-and-shift investor is still a value investor, but he takes some of the best moves from trading and incorporates them into his investment kung fu. In doing so, he'll be able to outperform purists from both camps. However, he must be careful not to borrow too much from the teachings of speculators. It's important to note that we're not talking about timing the market here. History has shown that to be an impossible endeavor for even the best investors. With buy-hold-and-shift, we don't care what Mr. Market is going to do tomorrow. We only care about the deal he's offering us today.
There will always be great deals to be found at some point. If there's one consistent thing about Mr. Market, it's that he's so inconsistent. The S&P's beginning and end points may not have been vastly different over the past decade, but there have been massive gaps between its tops and bottoms. Furthermore, stocks don't advance or decline in lock step. Over time, some of the positions in your portfolio will become overvalued or undervalued relative to the others. This is a certainty. By shifting your capital to take advantage of these mispricings, you can pull in a lot of extra return that you otherwise would've missed.
There is one crucial criterion that an investor must meet before he employs a buy-hold-and-shift strategy: he must possess superior knowledge of every position in his portfolio. When a stock he owns has not advanced relative to the others, he must be certain that it is indeed because it is undervalued and not because his original investment thesis was incorrect. If the latter is the case, infusing the stock with even more capital will be detrimental to the investor's returns - to quote Peter Lynch, he'll be pulling out the flowers and watering the weeds. However, provided that he meets this criterion, a buy and hold investor can profit handsomely from market volatility by adding a little shift to his strategy.