Chuck Carnevale's  Instablog

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. (QSII) 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. (QSII) 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. (ED) 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 (ED) 2.4% earnings growth.  With such slow growth, Consolidated Edison, Inc. (ED) 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 (PG) 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 (PG) strong 11.5% earnings growth generated a closely comparable 12%  shareholder return, excluding dividends.   Note that Procter & Gamble’s (PG) faster growing earnings generated $75,912.26 worth of dividends versus Consolidated Edison, Inc.’s (ED) $99,367.30.  Procter & Gamble’s (PG) 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 is over-valued and Ross Stores is in value.  Figure 9 shows Wal-Mart (WWT) 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 (WMT) shareholders lost a compounded (-3.8%) or over 30% of their initial investment due to overvaluation, even though Wal-Mart’s (WMT) business did well.

FIGURE 10  WMT 10 year price performance

Figure 11 shows Ross Stores, Inc. (ROST) a smaller competitor to Wal-Mart (WMT) with a very similar growth rate of 11.9% versus Wal-Mart’s (WMT) 11.6%.  However, Ross Stores, Inc. (ROST) 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. (ROST) shareholders earned an exceptional 16.6% return, better than either Wal-Mart (WMT) 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.