In the past several weeks share markets worldwide have been on a daunting roller coaster ride with the rising price of oil and the prospect of a continuing upward price spiral. The 11 March “Days of Rage” in Saudi Arabia came and went without incident serving only to highlight the wild nature of some of the prognostications currently being bandied about.
This week it is something new. On 11 March, an earthquake followed by a tsunami of biblical proportions rocked Japan. In the ensuing days, the world watched in horror at the unfolding drama of the frantic efforts underway to avoid nuclear meltdown at several nuclear plants hit by the tsunami.
Predictably, world markets are crashing at levels not seen since 1987. It is only a matter of time before we begin reading a fresh set of obituaries for the buy and hold investing strategy. As investors across the globe rush for the exits in panic, many look back and sneer at their buy and hold brethren who are patiently waiting.
A starry-eyed newcomer to share market investing gazes at all this in amazement and wonders what investing strategy is most appropriate for these troubled times. Perhaps the newbie might benefit from the thoughts of a wizened old skeptical investor.
In truth, to understand any investment strategy – from chart and signal driven technical analysis at the extreme to discounted cash flow models of fundamental analysis – one only has to look at how the strategy handles the three most critical aspects of share investing:
1. What and When to Buy
2. How Long to Hold in the Face of a Loss
3. How Long to Hold in the Face of a Gain
Technical analysis relies on charting patterns and sophisticated buy signals based on share price movement to tell investors both what shares to buy and when to buy and sell them.
Growth investors look for high P/E ratios and stellar future growth potential to tell them what to buy. They ignore the maxim to buy low and sell high in favor of buy high and sell higher.
What do buy and hold investors look for and when do they buy?
Buy and Hold investors look for shares of fundamentally sound businesses using multiple valuation ratios to sort the wheat from the chaff. If the current share price is below the intrinsic value of the stock as measured by the valuation ratios, they see the shares as a good “value” and they buy. If the shares are overpriced based on valuation ratios and their own independent analysis, they wait. Note the phrase – independent analysis.
Share market investors of all types benefit from skeptical thinking and doing their own research. If you find a report somewhere singing the praises of ABC shares, look for independent corroboration. If you find a report somewhere predicting the demise of ABC shares, look for independent corroboration.
Buy and hold investors favor dividend-paying shares with proven performance records of accomplishment. Those who repeatedly sound the death knell for buy and hold investing often ignore the core components of the kind of shares a buy and hold investor would buy.
The skeptical thinker notes many obituaries citing the collapse of a company’s shares over time as evidence the strategy no longer works. Upon further review, the skeptic realises a true buy and hold investor would never have bought the shares cited in the first place!
One example of an Australian share that should be of interest to the buy and hold investor is Commonwealth Bank of Australia. We are going to use the following five-year chart to illustrate the buying decisions typical of this strategy and how they can cushion losses. Here is the chart.
First, once a buy and hold investor decides to invest, they build the position at every opportunity. Opportunity presents itself at market downturns; assuming the fundamental strengths of the business have not changed. Some investors see the extreme drops on this chart as signals to get out. Buy and hold investors see them as times to get in.
Second, CBA pays dividends, as do most value stocks. Reinvesting the dividends builds the position and smoothes out losses averaged over time.
A skeptical thinker might concede some wisdom in this buying approach, but what of the other critical aspect – how long do you hold the shares.
There are really two decisions here – holding when the share price is declining and holding when the share price is rising. Those who believe buy and hold investing belongs in the cemetery love to poke fun at the notion of holding a share forever.
Some investing strategies apply rigid rules to these two decisions. If your shares drop 8 or 10% below the price paid, ask no questions; just sell. If your shares gain 20 or 30% over the price paid, ask no questions, just sell.
Contrary to the critics, buy and hold investors do not hold forever. American investor Warren Buffet – recently cited as the third richest person on the planet – does not hold forever. What he has said is his favorite holding period is forever.
However, buy and hold investors pay attention to the signals that scream SELL. Those signals all have to do with fundamental changes in the nature of the business. The buy decision is based on management performance, competitive advantage, and valuation. Changes in any of these components spells trouble and can send even a die-hard buy and hold investor straight to the exit doors.
As an example, consider the American company that once was the largest corporation in the world – General Motors. Early in its history, it qualified as a value investment by most standards. Once again, buy and hold critics love to cite holding GM shares until the final gavel came down in United States bankruptcy court as evidence of the folly of holding shares of a dying enterprise forever.
True buy and hold investors would have observed the changes at GM early on and gotten out. Despite the pronouncements of GM management in the early days of Toyota’s entrance into the United States market that all would be well, a skeptical and independent thinking buy and hold investor had only to look for evidence to the contrary.
So, to all newcomers to share market investing, buy and hold investing does not mean holding shares till death do you part.