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James A. Daniel, CFP®
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tafThe Advisory Firm Newsletter:  June 2011

Know when to hold them, know when to fold them:

The Buy and Hold Debate.

Yes, I am channeling a little Kenny Rogers and his song "the Gambler" this morning to make a point about buy and hold investing philosophies. This came about as I have been watching two stocks in particular and thought that they might provide a good lesson on why the market isn't a rational beast and if you try to rationalize it can cost you. I realize that many of you reading this invest using mutual funds or ETF's as opposed to individual stocks, but the same lessons can apply.

 

Is there anything wrong with buy and hold investing?

NO! Just to make sure we are clear, there is absolutely nothing wrong with investing for the long term. In fact using this strategy can keep you from making short term irrational decisions with your investments.

However...... if you are a individual stock investor (or fund investor as we will discuss below), make sure not to confuse "Buy and Hold" with "Buy and Forget". Businesses change, economies change, growth rates change - which can all lead to extended periods of underperformance in once hot stocks (or funds). With the technology changes that we see today, once thriving businesses can be out of businesses in just a few short years.

The Value Trap

I like a good value as much as anyone and can relate to investors that look at a once high flying stock and think, "hmm. That company seems to be doing well and the stock price is trading at all time low levels. I think it is a good value". This is commonly referred to as the "value trap" with investing. The problem is that we look at where a stock was trading at its peak and where it is now and try to rationalize that it must be "on sale" and a good value. That may in fact be true, but there are also instances where it could continue trading cheaply for a long time. The general reason is that growth rates slow and investors are not willing to assign such a high P/E ratio (price to earnings) that they did during the companies rapid growth stage. Cisco Systems is a great example of this.

 

Technology / Business changes

As mentioned above, sometimes new technology or competition can take a once high flying stock and make it a value trap as well. Case in point is both Nokia and Research in Motion, which have seen their share prices continue to fall with the new competition from smart phone makers. We will look at this in our case study below.

 

CASE STUDIES: Cisco Systems (CSCO):

Cisco pretty much defined the 90's as the technology stock to own. If you got in early and held throughout the bull run through early 2000, you would have made very large returns. But what about those that held through the tech meltdown in the early 2000's or even those that bought in the past couple of years? Well unfortunately the news isn't so good. Cisco is making more money than ever and has consistently grown revenues. So why isn't the stock going up? It is basically P/E compression, or the fact that investors feel like Cisco is now a mature slower growing company and are not willing to assign a P/E multiple of 50, 60 or even 100 times earnings for the share price. The charts below tell the story, the first is a 2 year price chart of Cisco and the second is a price chart from 1997 to present:

 

csco
cisco monthly

 

CASE STUDIES: Research in Motion (RIMM):

Research in Motion is the maker of the Blackberry phone. This company pretty much defined smart phones in the business world for most of the decade. It seemed as if everybody in corporate America had one of these handy phone / email / PDA units. In fact many still do, but as with all technology new competitors hit the market and the market share a company once had starts to erode. Below is a price chart of RIMM for the past 2 years, although it was just this year that the stock price took a huge hit. There were many folks trying to call a bottom in the low 40's just last month saying that RIMM looked like a good value. Unfortunately news broke last week and now it is trading in the high $20's. So much for a value play:

 

rimm

 

CASE STUDIES: S&P 500 (using the SPY etf):

In the above examples we discussed why "buy and hold" works for a period of time but when you "buy and forget" it can become a painful lesson. So what about investors that use mutual funds or Exchange Traded Funds, aren't they protected from this? Sometimes yes, sometimes no. You see economic news, market cycles, and investor optimism/pessimism can have the same effect on funds. Case in point: what if you purchased the S&P 500 via the SPY exchange traded fund or had simply purchased a large cap index mutual fund that tracked the S&P? If you purchased in the early 90's and sold in 2000 you did just fine. If you purchased in 2000 and have held for 11 years, well the chart below shows you why they call it the lost decade......

 

spy

 

SUMMARY:

So what is the point in showing this? It isn't to frustrate or scare investors from the market, but to have you pay attention to where we are in the economic cycle and invest accordingly. There will be bull markets in the future which will be followed by bear markets. With just a little attention to your strategy you can keep more of your gains in your pocket. A couple of points to remember on your investing journey:

  1. don't be afraid to take a profit.
  2. if you own a stock or fund that is going parabolic remember point 1
  3. a cheap stock can get cheaper
  4. the market can remain irrational longer than you can remain solvent
  5. rebalance your account periodically to lock in gains

 

© 2011 The Advisory Firm. All Rights Reserved.


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