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!

For more info on how I find undervalued oddball companies, check out my mini-course here:

5 comments:

  1. Nice article, but to be honest, there is too much of those thinking articles nowadays and less real investor and analysis work...

    ReplyDelete
  2. Frickin love the blog bro keep it up!

    ReplyDelete
  3. Nate, hope this post finds you well where ever you are

    I'm sitting here reviewing my new financials of QUCT, AShG, GCCO, CNAF, HNFSA, FBAK, BSND, NORSB, NULM, some odd pref issues and waiting patiently for my invite to the BWEL annual meeting, the QUCT one is in less than two weeks. I was hoping for some new Oddball insights but I see the blog has gone quiet for the summer. I had wrote a SA article on Ash Grove but decided as I had not finished with our position, I would keep still......hope your still at it Nate.....I'd love to have a discussion on BSND, as I'm not sure what to do with that company....I find their company perplexing...I'm not sure what Graham would do for it. All of these infrastructure companies are asset heavy, cash light operations. I know Buffett doesn't like them, although he did buy BNSF, but railroads are different animal..where IHRC and others is a value play, GCCO, QUCT, BWEL are land and water plays...more or less.

    ReplyDelete
    Replies
    1. Hi Olaf,

      I'm still plugging away, very busy with my software company.

      BSND is interesting, it's definitely floating around in the unlisted space. I've had a number of people mention it to me recently. I'd have to dig around, I believe I have results here somewhere. The company seems pretty cheap and is growing. But you're right, what do you do? Are they cyclical? Will they fall fast when the economy finally slows?

      Have you attended BWEL annual meetings? What were they like?

      And yes, I'm very overdue for a post on here...

      Nate

      Delete
    2. Nate,
      Good to hear you are out there!

      Understand the business plight, I just finished three book projects and two of my own. I'm writing 5000 words a day right now on a new project that may just be a waste of time....besides
      I'm junior partner on a wind turbine project that sold and sitting here waiting patiently to find what we got paid, what I'm getting paid...seems like a state secret....talk about il-liquid in the dark investments...can't really add to any positions pending if that is a wind fall (bad pun) or hot air...(okay I'll stop now). I also have some pref shares in a almost private bank due to convert here soon and not sure what they are converting to...could be cash. I'm not buying anything at the moment.

      I'm certain NULM is a sell at these prices and we have liquidated that and the only thing I'm leaning on selling in our odd portfolio is APTL, which having poked around Alaska, Port Angeles WA, this summer, and like the company, but it seems to be a trade although so thin, hard to get out, and may be even harder to get back in someday.

      BSND... Their earnings are odd, year over year doesn't make sense, got their AR on my desk. I think we own just 30 shares.....they don't match at all with ASHG or MCEM, and should be in the same cycle one would think. Their book value is hard to read as depreciated and what is any of that worth...railroad...IDK? maybe the railroad isn't of any value to a short line operator. No dividend, nothing....Every time I'm in Boston I have to drive around their plant, seems to beckon me to buy more. On a 2016 PE basis, cheap at these prices but
      guess I need to got to Boston and feel out the management.

      On BWEL, no, with a June 30th year end, usually due to my other passions, October/ Nov can be tricky times for me to get west..but I will if it just isn't in two weeks I need to be in the French West Indies, this year...I am sitting here wondering if I should go to Long beach for QUCTs on the 26th?

      Olaf

      Delete