Editor's note: This is the first in a multi-part series explaining value investing to novice investors. Please leave us your thoughts or suggestions in the comments section below.
My mother-in-law is known to my kids as Doodles. The name’s origin is a long story, but what’s important here is that she is extremely smart and a very capable businesswoman (she doesn’t go by “Doodles” professionally). Still, when we get together at the holidays, the stock market questions start:
“What’s going to happen in the market?”
“Should I buy XYZ stock? My advisor said its chart indicates it is ripe for a breakout.”
Doodles, I have no idea. I mostly engage in long-term value investing based on the fundamentals of the underlying business. So, maybe I should explain what that is so that you don’t mistake my silence for rudeness or me unfairly withholding magical stock market knowledge from my dear family. We can skip that part of the conversation and go straight to talking about my way of investing, or you can just let me concentrate on pouring gravy directly into my mouth.
(For the record, Doodles is just a proxy for every social acquaintance who has ever asked me a question about the stock market. If I am addressing a dumb statement, assume that it was an insane distant relative who inspired my commentary. If the question is nuanced and complicated, assume it was the work of Doodles.)
Two of the comments I hear all the time go something like this:
“I am down 50% in Terrible Business, Inc., but I am going to keep it because I am a buy-and-hold investor,"
“I heard a professional on TV say that the last 10 years have proven that buy-and-hold investing is dead.”
Both of these statements make a fundamental error in the interpretation of the concept of “buy and hold." They both assume that “buy” means “buy any random thing" and that “hold” means “never sell it under any circumstance." Aside from being a bad way to invest, “buy any random thing and never sell it under any circumstance" isn’t a very catchy phrase.
In fact, most stocks are not very appropriate for buy-and-hold investing. It only makes sense to plan to hold a business that is worthy of, you know… holding. Warren Buffett would look for such a business to have a “moat” -- what others might call a competitive advantage. As with castles, the bigger the moat, the more protection it offers. For a business, this might result in stickier customer relationships, faster and longer-than-average periods of revenue growth, or higher profitability relative to the rest of its industry.
These businesses tend to not be in fast-changing industries, because every time the industry shifts it's simply one more chance to get it wrong and screw up your competitive advantage. A business like Sysco
(NYSE:SYY), the dominant restaurant supply distributer, has a strong moat based on its scale and honing its business processes over many years. A major component of success in its industry is route density. The more customers Sysco has in a given territory, the more it can optimize the driver’s route and the truck’s load. It can also use its scale to order from its suppliers in optimized quantities and at volume discounts. Lower operating expenses give Sysco room to price just below its competitors and still be more profitable. It is extremely difficult for a competitor to replicate this advantage.
This is not to say that faster moving industries can’t still have moats. Motorola Solutions
(NYSE:MSI) operates in the communication infrastructure and device industry, selling to governments and commercial customers. While advantages here might seem fleeting at first glance (as the technology changes so rapidly), it is very difficult for many of MSI’s customers to switch providers. Governments are not typically the nimblest customers, so once MSI has proven its systems are reliable and the users have invested in learning the systems, there is much less chance of a new entrant stealing away the business easily. While the commercial customers might generally be more technologically nimble, MSI tries to sell to them on a more consultative basis. In the process, MSI learns valuable operational details about the customer that it can work into its proposed solutions. It is difficult for a competitor to get as full of a picture of the customer’s business problems, so it is hard to design as nuanced an offering. Though the timing
of a buy is a whole separate matter, once these types of businesses are bought, it is appropriate to hold them as long as the competitive advantage remains intact and the business is not obviously overvalued (assuming more compelling bargains are not available). Things like an earnings disappointment or a small cyclical glitch do not change the long-term thesis that, over time, the business will continue to eat other companies’ lunches.
Even if the initial intent is to buy and hold, there are valid reasons to sell. Sometimes a business with an intact moat can become irrationally overvalued. In his letter to Berkshire Hathaway
(NYSE:BRK.A) shareholders in 2004, Buffett hypothesized this might have been the case for Coca-Cola
and Gillette (bought by Procter & Gamble
(NYSE:PG)) during the late ‘90s bubble. Other times, the moat itself may begin to degrade (or at least become a little fuzzy). A historically well-run business like Staples
(NASDAQ:SPLS) seems to be priced very attractively by many metrics. However, Staples has been noting for a while that online competitors such as Amazon
(NASDAQ:AMZN) have been undercutting its prices aggressively. Is this changing industry dynamic the death knell for Staples’s moat? Maybe not, but it raises some questions that I would need to answer pretty compellingly in order to buy or continue to hold Staples as a long-term investment. Situations like this can easily become what are termed “value traps”: a statistically cheap stock with an underlying business that will continue to struggle, thus leaving the stock at perpetually (nominally) “cheap” prices.
Then there are some businesses which I’m not sure ever had much of a durable competitive advantage. Netflix
(NASDAQ:NFLX), the DVD and streaming-movie service, has been on a roller coaster ride over the last few years. I think at the root of this whipsawing has been a debate about Netflix’s vulnerability to competitive services and vulnerability to the whims of its content suppliers. Maybe Netflix actually does have a competitive advantage which will stick, but it is too hard for me to tell. In such cases, I simply pass and let the short-term traders play with it. (I realize that the recent quarterly results make my analysis seem asinine. My point is one of investment process, not investment outcome. I just think Netflix’s position is too uncertain for me to analyze. If I can’t analyze it, what’s the difference between such a trade and gambling? Others may have more insight, and may be able to better analyze the situation.)
When the topic of buying and holding an index or an ETF comes up as evidence that buy-and-hold investing doesn’t work well, I think this misses the point. Each is composed of good businesses with strong moats and less-competitive businesses with weak moats. If you buy and hold a mishmash of competitive moats, don’t be surprised if some of the underlying businesses do really well and some do extremely poorly. On average, your portfolio’s competitive advantage will be as mediocre as your investment returns.
So, Doodles, when you think about your next stock purchase, or your financial advisor says that you should hang onto that stock that has lost 50%, ask yourself what the underlying business and its industry will look like in five or 10 years. Will your candidate have taken market share (without killing its profitability) or have sustainably expanded its profit margins? If not, don’t fool yourself into thinking it is a candidate for long-term investing. And definitely don’t use it as evidence that buy-and-hold investing doesn’t work.
Now, if you will excuse me, I am late for a gravy-related event.