“Buy and Hold” Doesn’t Work If You Completely Ignore Valuation

The current bear market resulted in the first negative ten-year period for the U.S. stock market in a long time. This has prompted many people to declare that the investment strategy of buying and holding stocks for the long term (“buy and “hold” for short) is all of the sudden “dead” or no longer viable.

Personally, I find this death pronouncement a bit odd. Just because stocks went nowhere from 1999-2008 means that investing in stocks for ten years is flawed generally? Since when does one instance of something not working render the entire concept flawed? I don’t think a 100 percent success rate is required for one to declare it a viable strategy.

The reason “buy and hold” became popular is because, over long periods of time, stock prices mimic corporate earnings, which have risen over business cycles since the beginning of our economy. Legendary fund manager Peter Lynch continually reminds people that it is no coincidence that over decades the gains in the U.S. stock market are practically identical to the gains in corporate earnings (stock ownership represents a proportional share in profits generated by the firm).

The key point here is that the relationship only holds over long periods of time. In any given year, there is virtually no correlation between earnings growth rates and equity market gains. That is why “buy and hold” is a widely accepted investment strategy. If you invest over the long term, the odds are extremely high that earnings and stock prices will rise, and do so at higher rates than other investment alternatives.

I bring this up today because a former CEO of Coca Cola was a guest host on CNBC this morning. He and the CNBC gang discussed the fact that shares of Coke are actually down over the last ten years (since this person left the CEO post), as the chart below shows.

The CNBC commentators were quick to point out that Coke’s earnings have more than doubled over the past decade, but the stock has actually lost value. Does this example support the idea that “buy and hold” is a flawed strategy, or is there something else at work here?

The latter. Coke stock carried a P/E ratio above 50 back in the late 1990’s, during the blue chip bull market. Even when earnings grow dramatically, if P/E ratios are in nose bleed territory, “buy and hold” may not work, as was the case with Coke.

As a result, “buy and hold” does not work blindly. If you dramatically overpay for a stock, there is a good chance that you won’t make any money, even over an entire decade. From my perspective, this does not mean that “buy and hold” is dead (the long term relationship between earnings and stock prices is unchanged), it simply means that valuation is important in determining future stock price returns (statistics show it is the most important, in fact).

The take away from this discussion is that “buy and hold” investors are likely to do very well over the long term, as long as they don’t grossly overpay for an asset. The U.S. stock market in the late 1990’s was more expensive, on a valuation basis, than at any other time in its history. Buyers during that time can’t be saved from their own poor decision of paying too much for a stock, even by a proven long term investment strategy. Unfortunately, most non-professional individual investors don’t focus on valuation when picking stocks for their portfolios, and often pay the price as a result.

Full Disclosure: No position in Coca Cola at the time of writing, but positions may change at any time

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12 Thoughts on ““Buy and Hold” Doesn’t Work If You Completely Ignore Valuation

  1. Corey McGuire on May 19, 2009 at 10:57 AM said:

    Very well said. Valuation is everything. Making short term investment decisions based on long-term trends is what got real estate buyers in trouble. They simply ignored value and only looked at the upward price momentum.

  2. Tom Jericho on May 20, 2009 at 8:35 AM said:

    Buy and hope a 100% stock market allocation never was and never will be a working strategy. Does B&H work? Sure, if a) you’re diversifying along several asset classes, b) you’re reallocating regularly, and c) you’re wealthy enough to live off your savings for at least 5-10 years. Other than that – you better beware.

  3. Mark on May 20, 2009 at 4:47 PM said:

    The problem with investing over many yrs is it assumes bad recession years will be redeemed with strong bull markets and this will happen before you retire.

    This idea also takes a hundred years of data and makes it seem like you can expect the same returns in a small slice of time. From 1965 until 1983 the Dow Jones Industrial Average was flat. The index was at 1,000 beginning in 1965 and was at 1,000 in 1983. If you had bought the market and held instead of “timing” it there was a big opportunity cost.

    To me investing in just stocks over long time periods expecting consistency is no more of a fallacy than expecting housing prices to appreciate forever.

  4. Mark on May 20, 2009 at 4:50 PM said:

    also those amazing stock returns came from a country that in the economic sense is a freak of nature. Good economics and corporate profits can’t continue forever especially with Asia developing and our country slowing and taking on crippling deficits.

  5. Chad Brand on May 20, 2009 at 5:03 PM said:

    Your example excludes dividends, so actual returns were much higher over that time. You are right about historical subpar performance for the period you mentioned, but valuation played a large role in that, as my post discussed.

    The same goes for housing prices. Just because the bust has been horrible over the last several years, that doesn’t negate the fact that housing prices had never dropped nationwide before now. That didn’t ensure prices couldn’t fall, but it also doesn’t mean the long term trend is ruined.

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  10. Derek Pilecki on May 24, 2009 at 10:49 AM said:

    You made some very good points. I would extend the argument beyond valuation to include strength of the franchise. Buy-and-hold, as practiced by Buffett and Munger, involves investing in companies with strong franchises. As time goes by, the franchises either get stronger as profits are reinvested in the business to create a stronger brand or expand distribution or introduce new products. Sometimes, strong franchises get weaker because of shifts in consumer tastes, increased competition or regulatory changes.

    Using your Coke example, not only was valuation stretched in the late 1990s, but Coke’s franchise has weakened. Coke’s major market of carbonated soda drinks (CSDs) has stagnated. Consumers are shifting to healthier non-carbonated drinks such as water, iced tea and sports drinks. Coke missed a major opportunity to buy Gatorade’s parent, Quaker Oats, due to a board revolt against the CEO. Even though the price for Quaker was high at the time, the continued growth of Gatorade may have justified the acquisition. As a frranchise like Coke’s gets weaker, investors are less willing to pay high valuations for the stock.

    “Buy-and-hold” is not a “buy-and-forget” strategy. As you suggest, the entry valuation is extremely important. As time passes, investors also need to continually monitor the strength of the company’s franchise. As a company’s franchise weakens, investors should exit these long-term holdings.

  11. Valuation is potentially problematic when relied upon exclusively.

    How do you explain the single digit P/E Home Builders in 2005?
    The single digit P/E Investment banks in 2006?
    The single digit P/E Commercial Banks in 2007

    And all of the above in 2008?

  12. Chad Brand on June 1, 2009 at 10:04 AM said:

    I agree, using any one metric exclusively is suspect. Investors typically give trough P/E’s to peak/unsustainable earnings and high P/E’s to depressed/trough earnings, when it comes to cyclical industries like home building and consumer credit. Those single digit multiples were a sign that investors did not expect those earnings to be sustainable over the entire business cycle. Conversely, multiples are high today because investors are betting that current earnings are depressed.

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