“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