Is buy and hold dead?

I’ve read some articles lately suggesting that the time-honoured investment strategy of buy and hold is dead. Today’s markets are simply too volatile, the argument goes. Only active traders who are able to get in and out quickly can hope to make money.

To a degree, it’s true. Certain buy and hold strategies have proven to be non-productive in the current environment and should be avoided. One of them is popularly known as “couch potato investing”. This involves creating a passive portfolio using exchange-traded funds (ETFs). The theory is that if you invest in a small but diversified portfolio of index-based ETFs and don’t touch it, over time you’ll generate a decent return.

The reality is that you may have to wait a long, long time for that decent return to happen – probably too long for most people’s liking. The Mutual Funds Update newsletter has been tracking a model couch potato portfolio since January 2008. It has all the classic components — a 40 per cent weighting in a universe bond ETF with the other 60 per cent invested in three ETFs that track the TSX, S&P 500, and EAFE indexes. As of April 30 – more than four years since the launch — the portfolio showed a total gain of just 4.52 per cent. That translates into an average annual compound rate of return of 1.03 per cent. You would have done better in a high-interest savings account.

Purists will suggest that four years isn’t long enough to provide a meaningful test for the couch potato approach. That may be true but the human factor has to be taken into account. It’s one thing to play with numbers on paper. It’s quite another when those numbers represent your personal wealth. Few people would be willing to stick with an investing plan that has returned only 1 per cent annually over four years and carries a high degree of stock market risk. At some point, you have to move on.

But just because couch potato investing with ETFs hasn’t been a very productive strategy does not mean that the whole idea of buy and hold has been discredited. It still makes a lot of sense, provided you are holding the right securities. Just ask Warren Buffett. He believes in buying good companies and holding them forever and he’s done all right for himself and his shareholders.

Forever is a long time and I wouldn’t go that far. Even iconic companies that once dominated their industry can fall by the wayside. Think Eastman Kodak, Nortel, and the old General Motors. They would have been mainstays of a buy-and-hold portfolio a couple of decades ago and look what happened to them.

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So nothing is forever. But there are many securities that can be successfully bought and held for a long time. Here are the key criteria to look for.

Long-term growth profile. Call up a chart of the security that you are considering and look closely at the pattern over the past five and ten years. Compare it to a relevant index to see how it has performed against the broader market. You are looking for companies that are consistently doing better than their peers. You can find stock charts at Globeinvestor.com, Morningstar.ca (interactive), Yahoo Finance (also interactive), and the recently launched Canada Stock Channel (CSC) at www.canadastockchannel.com. The CSC site has a feature that allows you to compare the price performance of a stock with any of several indexes. However, the S&P/TSX Composite is not yet available.

Industry leadership. The top companies in their sectors are there for a reason. Moreover, history tells us they are likely to remain at number one for a long time. You’re creating a long-term buy-and-hold portfolio so why settle for second best? Market capitalization is one way of identifying which company is number one. Revenue is another.

Strong balance sheet. A sound financial underpinning has never been more important than right now. This means you’re looking for companies with good liquidity, strong assets, and relatively low debt (the latter will depend to some extent on the type of industry it operates in). Look at measures like “current ratio” (current asslike “current ratio” (current assets divided by current liabilities). If the number is less than one, it’s a danger sign. Debt to equity ratio is another popular measure. It is calculated by dividing long-term debt by shareholder equity. Utilities and telecoms, which have to invest heavily in infrastructure, will typically have higher debt/equity ratios but as long as the cash flow and profitability are good, it’s not an issue.

Good dividend record. Securities that have a long history of steady dividends and regular increases (preferably at least annually) are prime candidates for a buy-and-hold portfolio. There’s a good dividend history chart on the Canada Stock Channel website.

Relative strength in bad markets. No publicly-traded security is immune to market downturns. But some fare much better than others. Look closely at how a stock performed during the crash of 2008-09 compared to the market as a whole. You want securities that have a history of outperforming in such difficult times.

If you choose securities according to these guidelines they should fit well into a buy-and-hold portfolio and you’ll be happy to keep them there for several years to come — although maybe not forever.

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