How Buy-and-Hold Investing Can Work for You

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If you were a long-term investor and had bought equities back in 2000, you're sitting on losses today. The notion of buy-and-hold is generally a solid concept, but it's not as clear cut as it sounds. Sure, if you invest when you're 20 years old and hold on for 40 years, you'll probably do fine. But if you were 45 years old back in 1997 and started to seriously fund your 401(k) and investment portfolio, you're ready to call it quits after a decade of negative real returns.

Even though the markets are down nearly 50% since October of last year, many investors are ready to pull the plug and call it quits. The day-to-day volatility is brutal. But before completely giving up on equities, make sure you are looking at the market from a rational perspective. If you do, you will realize that there are investments to be excited about.

But first, investors would benefit tremendously from some sage advice from Ben Graham. You might not know this, but during the Depression, Graham's investment partnership lost around 80% in a single year. Graham was down, but he stayed the course, remained patient and, most importantly, he stuck to his fundamental approach.

Graham was following his own advice: In the short-term the markets are voting machines, but in the long-term the markets are weighing machines. Translated: Sooner or later, stock prices will follow those businesses that continue to improve fundamentally.

Right now the votes are being cast, and they are overwhelmingly negative. And to be sure, many businesses won't make it through or will do so only to lead a life of mediocrity. Such is the beauty of free-market capitalism. But many others will get out of the recession and prosper.

As investors find themselves at the end of one the worst years in market history, it's instructive to step back and examine the situation rationally as you head into 2009.

Back in 2001, I began buying refiners, namely Tesoro (TSO) and Valero (VLO), paying 4 and 5 times earnings respectively. I got in at around $8 for Tesoro. In 2002, the stock hit a low of 60 cents as earnings went from $1.05 a share in 2001 to a loss of 97 cents in 2002. In 2003 the stock was still languishing trading between $1 and $7 during the year. The stock was performing poorly, but the company's fundamentals were sound and the balance sheet was strong. In 2005 I sold at around $30, and two years later the stock was trading at $65.

The experience was similar with Valero. I held the shares for four years, the first two of which I was down on my investment. In the end, the result was a gain in excess of 300%.

Today's recession is different from the 2001 recession. But it does show the short-term voting machine vs. the long-term weighing machine of the markets. Depending on the prices they paid, investors in Apple (AAPL) were sitting on losses for three years before earning a return, and what a return it was. If you bought at the high price in 2000, the 2001 recession cut your investment by up to 80%. You can see what happened when the market votes were outweighed by fundamentals, beginning in 2004 and beyond.

As we look ahead to 2009 and beyond, understand that strong fundamentals will eventually be reflected in the market. I wish I could tell you that the market will definitely turn in 2009. But what we do know is that recessions will pass and that lots of great companies come out of them stronger. The key is to think about holding periods. If you buy at $30 and the share drops to $15 but recovers to $60 over a four- to five-year holding period, that's a very respectable rate of return.

The key of course is the business itself. An easy choice today is Johnson & Johnson (JNJ). It's one of the finest companies around today, with great growth potential still ahead. And the 3.2% dividend is nothing to sneeze at.

In recessions, all corporate profitability is affected. Just as it's crazy to use last year's peak earnings for future valuations, don't assume that all businesses will never report growing profits again. Look for businesses that will make money when the situation improves. Areas to consider would include oil, infrastructure and health care.

This was originally published on RealMoney on Dec. 5, 2008.

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