Buy and hold is dead. Long live buy and hold.

My foray into investing was similar to most.  I found myself with a bit of extra cash and wondered "how can I earn more than 5% with this?"  Of course all of the wise and savvy people in my life such as co-workers and parents all said "invest it!" But I didn't know what that meant.  I did what any book worm would do, went to the local library, found the aisle with investment books and proceeded to check a few out.

I read all sorts of books about investment, some terrible, some interesting.  My library seemed to operate on a rolling calendar basis that was about a decade old.  That means most of the books I was checking out in 2005 were from the early to mid 1990s.  There were books on the Dogs of the Dow, and Beardstown Ladies, as well as Stocks for the Long run and many others.  The books all had a common theme, it was that savvy investors used a technique called "buy and hold."  What this meant was investors should scour the investment universe for anointed blue chip stocks, buy them at any price, and hold them forever.

The concept behind buy and hold makes sense.  You buy market leading companies, hold them, and throughout time your shares naturally appreciate.  From the end of WWII onward buy and hold was a brilliant strategy.  With the industrial hearts of Europe and Asia decimated from war the US had a natural industrial advantage.  Those blue chip stocks grew and grew and grew.  Investors would buy, hold, and re-invest their dividends for years.  Some companies even developed specialized programs where investors could invest directly with them and reinvest their dividends in partial shares at a slight discount to the market rate.  The system was focused entirely around buying these quality blue chip companies and holding them forever.

The system can't be faulted, it worked!  I know of people personally who worked for GE and other blue chip names in the 1960s-1990s who invested their entire retirement in company stock and retired a millionaire.  These weren't executives either.

Then a man named John Bogle came along and created a better buy and hold system.  Most investors were only buying blue chips, and blue chips were the main constituents of stock indexes.  This meant that at best the performance for most investors approximated an index.  The problem was that even though investors were approximating the index they were failing to match or beat its performance.  This was due to frictional trading costs, or just bad decisions.  The idea that one could buy an entire index in a mutual fund with low fees, sit back and do nothing more and earn higher returns was attractive.  From Bogle's initial concept Vanguard was born and grew into a juggernaut.

A curious twist has happened in the years since.  Index investing has overtaken buy and hold and become its own investing religion.  Along with this value investors have gone full circle.  From deriding buy and hold as an unintelligent strategy to embracing and proselytizing it.

Value investing drifted from buying companies that were disproportionally cheap to buying companies that earn above average returns that can be held forever.  Does that sound familiar?  It's buy and hold with new terms.  Instead of "blue chip" we have "compounder" and instead of "market leader" we have "high ROIC."  These compounders are discussed as being such good businesses that investors don't need to focus on the price they pay.  All one needs to do is buy them at any price and hold on for decades.  These companies will somehow grow to the sky and make everyone rich.

Is it any wonder that most funds fail to match their index?  They're back to working with a strategy where it'd be much better to buy the index.

So what's the alternative?  It's my belief that for most companies there is a price where they should be purchased, and a price where they should be sold.  No company grows at 20% forever, the math works against them.  Take a company earning $1b growing at 20%.  After 20 years of growth they're generating $38b in income.  After 30 years of growth it's $237b in income.  And 40: $1.4T, and 50: $9T, and 60: $56T.  A company that starts with $1b in income and grows at 20% a year for 50 years will be earning more than the entire GDP of the US in slightly over 50 years.  Is that realistic?

Let's also note that very few investors get on board when the company is earning $1b, they latch on after 15-20 years of growth once they have a long track record.  It's at this point that most of these companies are hitting their peak scale and growth starts to taper off.

Investors like to delude themselves and say that they know better than most what the future will hold.  That they'll only buy companies that can grown earnings 20% for the next twenty years.  Think about how crazy that is.  Let's go back 20 years.  What companies were going to take over the world?  How about Gateway Computer, they were an all-star.  They had stores, they had cool commercials, they were a popular brand.  They vanished in a string of mergers.  Maybe Apple?  Back in the late 1990s it was a lame computer manufacturer that was on the brink of death.  The weekly Best Buy ads would have them in a line-up compared to other Mac clones as well as PC's.  The Apples always had the worst specs and highest price.  No one would have guessed they'd become a dominant brand selling cell phones.  Back then Motorola was cleaning up with their StarTAC phone.  The cell phone world belonged to Motorola and Nokia.  Yet twenty years later those companies exist in name only now, a bet on them in 1997 would have ended in pain and misery.

Of course a few readers will say "Amazon and Google", which is perfect hindsight bias.  Now that they're the market leaders we all "knew" they'd be like this in the late 90s didn't we?  I remember back then AltaVista was killing it in search, same with Lycos.  Amazon was interesting if you wanted books, but that's all they sold.

There are times when the market is pricing a company too low given their future prospects, or even current prospects.  It's during those times when an investor should purchase shares.  But just as the market likes to undershoot it also likes to overshoot.  And companies that were formerly undervalued can become just as overvalued.  Instead of holding on by justifying a low cost basis it's time to cut the cord and take gains.

Holding too long can become dangerous.  I know of an investor who purchased a deeply undervalued company in the early 1980s.  They held and the stock grew by almost 100x.  His investors who cashed out at that time profited from his holding, but he continued to hold.  As of a few years ago the stock was below his cost basis from the early 80s.  The company went full cycle, from small to an all-star and back again.

If you don't know when to buy or when to sell you might be telling a similar story some day.  It's time to buy a company when they're trading at a deep discount to either their assets, earnings, or the M&A multiple of their peer companies.  The metrics on selling are different, and maybe this is what trips investors up.  When a company appreciates you need to evaluate them differently.  Look at the growth the market is pricing into the stock and estimate if that's appropriate.  Also look at the trajectory of the company's revenue and earnings and estimate if those growth rates seem appropriate.  There are times when you can buy a company at 50% of book and sell at 100% of book when nothing in the business has changed.  But more often something has changed that ignited the move, and usually what's changed is earnings so it's the earnings that need to be evaluated.

The only way to earn above average returns in the market is to do be doing something different than the market.  You can't be doing something different if you're mostly buying large constituents of the indexes and holding on.  Remember that every price has a point where they're a buy, and everything a sell.  For those of us who adhere to this the idea that most of the market is buying and holding blindly is a good thing, it means more opportunity for us.  So seize that and profit!

Are all "Graham" stocks junk?

Have you ever walked down the street and inadvertently stepped on a piece of gum?  It's annoying.  A piece of previously enjoyed food carelessly discarded on the ground and is now stuck to your shoe.  In many ways investing in the mold of Benjamin Graham is like a sticky piece of gum on the street for most investors.  It's an idea that had merit seventy or eighty years ago, but is old fashioned and is now stuck to everyone's shoes.  Most value investors have spent a considerable amounts of time metaphorically scraping Graham's ideas from their shoes.  But amazingly there are still a few still chewing on that old gum and enjoying it, why?

The common sentiment is that Graham-esque stocks, that is stocks that trade at low valuation multiples such as a stock trading at10x earnings and 75% of book are junk and a waste of time to research.  The implicit assumption in all of this is that the market is somewhat efficient and if a business trades for a poor multiple it must have some problem that makes it deserving of the low multiple.

A company might be deserving of a low multiple because there is fraud, or they retain a management team that has decided to loot the coffers.  Although ironically fraudulent companies often earn praise and high multiples from the market until the day they fail, a la Valeant.

The stereotype of a value stock is a company producing shag carpeting run by managers wearing polyester suits with elbow pads who are wondering why sales are declining.  This can be the case sometimes, but it's more of an outlier than the norm.

I think the greater problem with Graham type stocks is they are in unattractive industries, and investors don't like to be out of step with the market.  I ran a screen for stocks trading below 75% of book value and for less than 10x earnings.  The resulting small list contained some sketchy biotech companies, a number of even sketchier Russian mining companies, as well as a few other resource and industrial companies.

These companies with depressed valuations don't appear in anyone's quarterly shareholder letter, and they aren't on WhaleWisdom.  In a perverse sense the increased socialization and ability to network with other investors via the Internet has made this problem worse.  I've heard of investors who search Twitter, Seeking Alpha and hedge fund letters for ideas.  If an idea isn't "approved" by someone well known in one of these circles it must not be worth researching.  The idea is that these high profile managers or prolific Internet posters spend all of their time reading and scouring nooks and crannies for stocks.  So they must have looked at everything already, and if they didn't buy it then it isn't worth buying.

Just because a name doesn't appear on Twitter, or in hedge fund letters, or on Seeking Alpha doesn't mean it's a bad idea, or it's not worth researching.  There are still plenty of areas that are inefficient, and stocks that are out of favor is the biggest area.

People like to be liked.  It's easy to be liked when you're doing the same thing as everyone else.  This is true for all aspects of life.  In sports-crazed cities it's difficult to cheer for an out of town team.  Groups of friends all have similar interests and views.  Political parties change direction often, but party followers keep toting the line.  The market is just a group of people too, and the market collectively likes things like any other group.  These likes and interests are echoed on TV, in letters, and in public speeches about investing.

Currently the market likes artificial intelligence, self-driving cars, automation, mail-order catalogs presented as websites (what is old is new again..Amazon the new Sears?), companies with high ROE's regardless of how they're generated, compounders and moats.  This wasn't always the case, at periods in the past the market's interests were different, and they'll change again in the future.  Yesterday's Nifty Fifty is today's IBM with investors running for the exists.

In large the market points in the correct general direction.  In the 1990s it pointed towards the Internet becoming a thing, it did become a thing.  In the 2000s it pointed towards financialization, which is still a thing.  The finer details aren't always correct, but the general direction usually is.

If a company isn't part of the cool kids club they might be able to float alongside for a while.  Maybe they'll toss a few keywords in their proxy about automation and technology innovation.  Or maybe their high ROE is good enough for a while.  But eventually those wannabes fall by the wayside.  Sentiment shifts and somehow a wannabe becomes a left behinder.  For years resource companies were the cool kids, now suddenly no one will touch them.  Airlines spent a long time in the ditch, but now they're suddenly cool again.  This is the popularity cycle at work.

One of the foundational concepts that Benjamin Graham taught was that there can be value where others don't believe it exists.  What he didn't say was "buy everything no one else likes."  He said to go poke where others aren't poking, because sometimes the baby is thrown out with the bathwater.

It's in these pools of dirty bathwater that deep value investors go searching for babies.  While the pool might be dirty the discovered baby isn't.  To beat an analogy to death.. the babies we're finding are cute and innocent, unsure of why they're laying on the street out the window in a puddle of bad water.

This is the essence of value investing.  Looking where others aren't looking, but sifting the bad from the good.  The idea is to find companies that have been marked by the market as bad that aren't.  Since these companies aren't bad like the market suggests, their goodness will eventually shine through for investors to notice.  When this happens their price will appreciate to be in line with other similar companies, not the mis-matched peers they were previously trading with.

Like everything in life investing is a popularity contest, and Graham style investing is not popular at the moment, just like the types of stocks it uncovers.  This doesn't mean the strategy isn't profitable.  It's actually the opposite, excess returns are found outside of the main stream of popularity.  I'd wager that a set of randomly selected set of companies trading at low P/B and low P/E ratios will outperform the FANG stocks, or Tesla over the next three to five years.  But this isn't a popular notion, and no one wants to be caught writing about a no-name value stock in their quarterly letter.  And that's why this opportunity exists.