A successful self trader – Rule # 35
Nobody doubts that equity generates higher returns in the long run; at least in most cases. As much as the “Buy-and-Hold” approach to long-term investing works, it has its limitations. There are 3 risks in any buy-and-hold strategy. You may be accumulating junk stocks, you may be out of sync with the times and your funds may be just locking up. Equity creates value in the long run, but, not always!
Buy and hold is not an all weather strategy in markets
When investors say that a buy-and-hold on Infosys may be the best thing that could have happened to them, we immediately remind them of Satyam. As much as a buy-and-hold strategy is logical and seductive to investors, it has its limitations and caveats which most investors do not understand. Looking back it looks so simple; but looking ahead is the problem. That’s the crux.
In many ways, buy and hold strategies are like driving with a rear mirror view. It always seems so simple in retrospect. Infosys, Eicher, Hero Honda are all the stuff that value legends are made off. But each of these stocks was an extremely tricky bet 10-20 years ago. To understand this point, just ask yourself; which stocks will you commit your funds to for the next 10 years?
A buy-and-hold decision becomes critical as you allocate funds to these ideas for a long period of time. And money, obviously, has an opportunity cost. The second problem is psychological. Can you remain an ascetic and hold on when other stocks are soaring? Lastly, there are those umpteen liquidity needs which will force you to make a choice between now and next year.
3 reasons a buy-and-hold is actually challenging:
Am I missing out on other opportunities?
Most value stocks play out after a tipping point. These can take between 3-10 years. During this period a thousand trends and a million stocks will soar and pass you by. Are you prepared to see other stocks soar as you stagnate?
I can explain to my heart, but not to my mind
Buy and hold is often played out in the mind. A fund manager has benchmarks. How long can they underperform? What if stocks fall for extraneous reasons? More often than not, your doubts will prevail.
Overcoming the many liquidity challenges
The buy-and-hold stocks have the ability to suck out your liquidity and test your patience. More often than not, these value stocks end up as a choice; tomorrow’s possible value or today’s liquidity gaps. That is tough.
“Forget stock prices. Our holding period for stocks is Forever” – Warren Buffet
6 guidelines to avoid the buy-and-hold trap
- More often than not it is a disruptive technology. Examples: Smart phones for Nokia, Online retail for Future group, Motorcycles for Bajaj Auto etc. Buy and hold will work for companies like Bajaj Auto which were quick enough to understand and radically adapt to the new trend. Watch for adapters.
- The best way to destroy your long term value is to take on too much debt. Classic case is of infrastructure companies in India. Take RCOM, Jaypee group, GVK and GMR. All of them are in a business sweet spot but have been subdued by too much leverage. They are not buy-and-hold candidates.
- Loss leaders can never be forever. Don’t every try a buy-and-hold strategy on companies following a loss leader strategy for market share, with no credible plan to translate these into profits. Kingfisher, Jet Airways and many e-commerce companies are cases in point. No buy-and-hold here.
- For buy-and-hold to work, you must buy as close to the tipping point as possible. The tipping point is when the volumes and market share decisively start translating into profits. Infosys in 1998, Bharti in 2005 and Eicher in 2011 are all examples of tipping points. Closer you buy to the tipping point the better it is.
- Great buy-and-hold candidates are also backed by great managements. Managements that are opaque, have too many group transactions or keep diluting equity are rarely buy-and-hold candidates. It is not surprising that companies with high governance standards have created maximum value.
- And finally remember what Peter Lynch said, “Value creation is inversely proportional to a chic office”. In a nutshell, long term value creators are extremely conservative on managing costs and diversifications. The over-spread names like Kingfisher, Deccan Chronicle were always courting trouble.
Remember, the devil lies in the detail
If you look back at value stocks the devil has always been in the detail. Apple became a value creator when it pioneered the concept of smart phones for masses, almost a replacement for the PC. When the industry viewed buses and vans as a stable industry, Eicher saw the billion dollar opportunity in clunky motorbikes. Infy was the first to realize that low operating costs and a weak rupee was a sweet combination. Buy and hold is all about detailing.
The second major consideration in buy-and-hold is to separate the wheat from the chaff. When Infosys was appreciating, there were hundreds of wannabe tech companies, which were also appreciating. Same applies to telecom wannabes and pharma wannabes in the last 20 years. The challenge is to separate the Bhartis, Infys and the Sun Pharmas from this list. And therein, probably, rests the biggest challenge in a buy-and-hold strategy.
Takeaways from the “buy-and-hold” debate
From Ben Graham to Buffet to Lynch, a strategy based on buy-and-hold has worked and it has worked with incredible success. It is just that it is not as simple as it appears to be. The success ratio is low; the odds are high and more often than not people lose the battle of the mind; not so much the battle of identifying the stock. That is the real challenge.
The bigger question is whether in a volatile market, driven by liquidity and leverage, a buy-and-hold strategy make sense? I am sure it does, but a lot less than it made in the last 20 years. As trends change faster, money moves quicker and economic and business fortunes fluctuate more wildly, a fleet footed approach may make more sense. It may be too early to write a requiem for the buy and hold strategy. But the so-called long, long-term investors, better watch out!