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Right now, investors are seeing the major downside to the buy-and-hold strategy - what happens in a savage bear market.
One of the most straightforward sharemarket investment strategies is ‘buy-and-hold’ investing, where you simply buy a portfolio of stocks and hold them for the long term. If you stay in the market long enough, the theory goes, you minimise the risk that your portfolio may lose its value and you allow compounding to get to work on the capital gain and dividend income on your stocks.
Buy-and-hold taps into the capacity of the stock market to generate very strong investment returns over long periods of time. According to Shane Oliver, Head of Investment Strategy and Chief Economist at AMP Capital Investors from 1900 to December 2008 Australian shares have delivered a total return (capital growth plus dividends) of 11.9 per cent a year on average, with more than half of that return – 6.2 percentage points – coming from dividend income. In real terms, the return is 7.8 per cent a year.
Given the right stock, buy-and-hold can be staggeringly effective. In Australia, the greatest documented buy-and-hold success story is Westfield. If you had invested the equivalent of $10,000 (in today’s dollars) in the float of Westfield in September 1960, and reinvested every dividend and bonus issue that Westfield paid, your investment in Westfield Group at the end of June 2005 would have been valued at about $167 million.
At the time, Westfield had delivered a 30.9 per cent compound annual return, versus 10.9 per cent for the All Ordinaries Index over the same period. (The group no longer calculates the figure for inclusion in its annual report).
The Australian Securities Exchange (ASX) reckons this is the best example of long-term wealth creation of any stock it has hosted. Sure, this figure is a gross calculation and doesn’t take into account how much money has been reinvested. However, the point is that no other money was needed than the original investment.
“There are multi-decade superb performers like Westfield, and QBE is another, where holding this kind of stock over the long term can really be the foundation of a personal fortune,” says Graham Harman, head of investment strategy at Citi.
Any serious investor would associate buy-and-hold strategy with Warren Buffett, its most famous advocate. Buffett’s track record as a buy-and-hold investor (through his New York-listed company, Berkshire Hathaway) is undoubtedly impressive: his Chairman’s Letter in the 2007 Berkshire Hathaway annual report) reported that the company’s book value (net tangible assets) per share had increased at a compounded annual rate of 21.1 per cent since 1965, compared to an average of 10.3 per cent for the S&P 500 (including dividends). Not surprisingly, the niche publishing industry that has grown around the doings of Buffett has popularised buy-and-hold as one simple method of trying to emulate the master.
But right now, investors are seeing the major downside to the buy-and-hold strategy: what happens in a savage bear market. Then, investors can find that a significant portion of the profit they have built up gets wiped out.
The sickening volatility that has characterised the stock market since late 2007 means that Buffett-style buy-and-hold investing is “dead for the next ten years”, says another investment guru, Dr Marc Faber, editor and publisher of The Gloom, Boom & Doom Report. Faber says buy-and-hold will not work in an environment of very high volatility, where investors have to deal with constant moves of 20 per cent both up and down. Under these circumstances, says Faber, investors should refrain from holding stocks even for one to two years: he says the market is now a “trader’s market.”
Certainly, to have held any of the following in 2008 would have brought serious pain to a buy-and-hold portfolio:
- Babcock & Brown: –99.4 per cent
- Babcock & Brown Power: –97.1 per cent
- Valad Property Group: –96.5 per cent
- Babcock & Brown Infrastructure: –94.7 per cent
- ING Industrial Trust: –94.3 per cent
- Macquarie DDR Trust: –93.9 per cent
- Centro Retail: –93.5 per cent
Harman does not believe the strategy is dead. The attraction of buy-and-hold investing, he says, is that the strong performers are unlimited in their gain, whereas losses in the duds are limited. “A star stock can easily give you a tenfold return, whereas a dud can only lose you all the money you put into it.
“You could just as easily have had Pasminco or HIH in your portfolio, and lost your entire investment in those stocks. But for every Westfield or QBE or Newcrest you capture, you can afford the odd Babcock & Brown – unless your duds outnumber your stars by more than nine to one.”
The present 14-month, 51 per cent slump on the Australian sharemarket represents its worst-ever plunge. But while the bear market has erased massive amounts of market capitalisation, Harman says it is not hard to find stocks that continue to perform well over the long term.
The following table shows the annualised total return from those stocks in the S&P/ASX 20 Index that have a ten-year history, up to the onset of the bear market in November 2007 – and what the bear market has done to that annual return. While the slump has savaged returns, some remain very respectable.
Some of the S&P/ASX 200’s best performers show still-stratospheric per-year returns. Fortescue Mining is running at 60.9 per cent a year, down from 91 per cent, while Paladin Energy is showing 40.5 per cent a year, down from 59.4 per cent a year in November 2007. But these resources stocks are highly volatile at present, and do not generate dividends. Many less-risky, dividend-paying S&P/ASX 200 industrial stocks, with sound businesses, continue to earn their keep as solid buy-and-hold candidates:
Harman says many investors mistakenly believe that buy-and-hold is a stock-picking strategy. “It’s actually reverse stock-picking. If you’re going to capture as many star stocks as possible, it has to be a ‘scatterplot’ approach.
“There is a fair bit of ‘survivor bias’ in looking at buy-and-hold returns. How would you have known, ten years ago, which stocks were the best buy-and-hold candidates? I think buy-and-hold is still a great strategy, but that’s because you don’t know what the successes will be – not because you do know what the successes will be. You’ll only know that in hindsight, so you need to hold as many stocks as possible, so that you don’t mistakenly sell the multi-decade superb performers like QBE and Westfield too early.”
Tax can also be a major consideration. Ideally, says Harman, a buy-and-hold investor would leave their capital gains unrealised and take their profits as franked dividends in perpetuity, not as capital gains.” As an investor, your greatest single defence against the ravages of tax is to do as little as possible,” he says. But on the flipside, he cautions that an unwillingness to crystallise tax gains can lead an investor to hold on too long to duds when they go sour.
Jamie Nemtsas, director of Investstone Wealth Management, says buy-and-hold is not – and was never – “buy, hold and forget”.
“Whether you’re self-directed, or in conjunction with your adviser, you should always be monitoring the portfolio, and be ready to make changes. Our clients hold 20 stocks, 18 of which are in the Top 20 and it’s fairly evenly balanced. Every time one of the positions becomes greater or smaller than the average, on a six-month or 12-monthly basis, we rebalance it.”
Nemtsas gives the example of a $400,000 portfolio comprising 20 stocks worth $20,000 each. “Say that a year later, one of the stocks, BHP, is worth $45,000. We would take that $25,000 profit and put it in fixed-interest. You should be constantly rebalancing and taking profit, because the adage really is true: you don’t go broke taking a profit. Rebalancing is the easiest thing for a retail investor to get right,” says Nemtsas.
Gary Stone, managing director of ShareFinder Investment Services, which markets a mechanical trading system, says the bear market of 2008 has “exposed the limitations of buy and hold once and for all.”
“Buy-and-hold has seen investors right for 20 years, but now many of them are looking at a 50 per cent drawdown. They’re now looking for a risk management strategy whereby if this happens again, they’ve got a way of getting out.”
Stone says buy-and-hold has to become ‘buy, hold and monitor’. “You can still have stocks that you want to own, but you have to have the exit strategy set in place beforehand. Even though it might be as simple as a break of a trend line, or a 10 per cent or 20 per cent stop-loss, you have to have something that will get you out, because no-one can feel safe from another 50 per cent drawdown. It’s unlikely, but we now know that it’s not impossible.”
Ten years ago, he says, investors were conditioned to buy-and-hold mainly because they lacked the knowledge and the tools to monitor a portfolio adequately. “Very few people had access to a charting package and even knew how to do a trendline. But the technical analysis tools are readily available, and there’s no excuse for not combining that with fundamental analysis. These days, a held stock has to be re-tested constantly for its validity in the portfolio – we would recommend at least weekly,” says Stone.
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