Buy and Hold: Alive and Well

I find it interesting that so many stories have been popping up in on television, the internet, and investing magazines proclaiming the death of "Buy and Hold" as investing strategy. It is perfectly understandable after the horrendous performance of virtually all world stock markets. I assure you, however, that properly understood and implemented, buy and hold remains a viable and productive investment strategy.

First of all, buy and hold doesn't work for all types of investment assets. It works perfectly well with broad market index mutual funds and exchange traded funds as well as well-diversified and well-managed stock and bond funds. It does not work well with cyclical stocks that pay little or no dividend. It works very well with fundamentally strong companies in non-cyclical or defensive industries that pay good dividends. In fact, it is exactly times like these that make buy and hold work so well with the right kinds of assets.

How can buy and hold work well when the market goes down? Reversion to the mean. Let's look at a simple example. Say you buy 100 shares of company XYZ at $20 per share for a total investment of $2000. Let's also say that XYZ pays a 5% annual dividend, or $0.25 per quarter per share. After three months let's say that XYZ has lost 25% of its value. That would leave you with 100 shares of XYZ at $15 per share plus $25 in dividends reinvested at $15 per share for a total of 101.67 shares. Now let's say that XYZ continues to slide to $10 per share in a severe market downturn, yet it remains a fundamentally strong company. After reinvesting the quarterly dividend you would now have 104.2 shares of XYZ at $10 per share for a total value of $1042. In the second half of the year the market starts to recover bringing shares of XYZ with it back to $15 per share. Now after reinvesting the quarterly dividend you would have 105.94 shares of XYZ for a total value of $1589.10. And now by the end of the year the market has regained its original level bringing XYZ with it back to $20 per share. After reinvesting the dividend you would have 107.26 shares of XYZ at $20 per share for a total value of $2145.29 for a total return of 7.3% in a market that went nowhere in 12 months. Had you not reinvested dividends the return would have simply been the 5% dividend. Had you invested in a stock paying no dividend your return would have been zero for 12 months.

If you know the stock is going to go down, why not just wait and invest at a lower price per share? Well, that makes complete sense, but who knew before the fact that the stock market was going to be down so much in 2008? In fact, if you know a stock is going to go down, why not just short it? Hey, simple! But you know it is not really that simple. I know of no major investment analyst or columnist that knew that world markets were going to perform as poorly as they did in the last year (aside from a few gold-bugs that have been predicting armageddon every year for the last 15 years - even a broken clock is right twice a day). How about if you were a trader and set stop-losses or bought puts, etc.? Who knows? Depends upon your level of expertise, skill, timing, and trading strategy, however, studies show that the vast majority of traders under perform that market averages.

The above example shows pretty clearly why not all stocks qualify as good candidates. Stocks that pay little or no dividend do not present the opportunity to profit from reinvesting at lower levels. Stocks of companies that are not fundamentally strong reduce the likelihood that they will at least perform as well as the market over the long term. Financially strong, market leading companies with strong competitive advantages and good management can actually use severe market downturns to gain market share from weak rivals and may in fact benefit over the long term. And well-managed, defensive/non-cyclical companies tend to outperform the market in severe downturns and present stock patterns with more of an upward bias compared to deep cyclical companies.

So, does this mean you should never invest in non-dividend paying companies? No, not at all. It just requires a slightly different strategy. For example, I own Cisco Systems (CSCO), the large networking equipment company. I realize that technology companies are cyclical, but I still consider them a growth industry compared to, say, chemical companies, like DuPont or Dow Chemical. CSCO pays no dividend but they are fundamentally very strong with billions in cash on their balance sheet. In severe market downturns CSCO tends to use their strength to acquire competitors and take market share by offering financing to customers while continuing to invest in research and development. In the last 12 months, CSCO is down from about $27 to about $17, with a 52 week low of $14.20. While I have not benefited from reinvestment of any dividend as CSCO doesn't pay one, I have used the drop in the share price to add to my position in the stock. When CSCO recovers, which I believe it inevitably will, I will participate in its recovery. Could a trader outperform me? Sure, its possible. But statistics say it is tough. A better strategy might be to use options, but that doesn't come without a cost.

Have you heard the expression, "Buy when there is blood in streets?" What that is basically saying is that you make money in investing in the stock market when the market is so bad that nobody want to own stocks. In other words, the best time to buy is when the conventional wisdom is to sell. Well, right now might be the time to sell the idea that "buy and hold is dead" and buy "buy and hold."