The most successful investor of all time, Warren Buffett, is famous for saying that if you pick the right stock, then you should never have to sell it. In fact, he is probably the most famous buy and hold investor of all time. For example, even in spite of Wells Fargo recent fake accounts scandal, Buffett still has yet to sell any of his WFC shares. Why does he do this? Is he mad? No one can invest like Buffett, but everyone knows his philosophy. Why? He’s written about his investing philosophy extensively in his annual letters. This post hopes to explain in an intuitive way why a “buy and hold” strategy does increase the value of your investments in the long run (as well as it doesn’t). This will also explain why a company with stagnant yet consistent earnings does increase in value every year.
First let’s define “value”
For the sake of this post, let’s define “value” as being the sum of your earnings power and cash on hand. Also, for simplicity, let’s just say the fair value ratio is P/E. So if Company X makes $100 million per year and has $50 million on hand, then X is worth $100*P/E+ $50. This post isn’t meant to be mathematical heavy so I’m intentionally simplifying things for understanding, but I think this is a very intuitive valuation of a company.
Now let’s discuss why it works
The easiest case is when earnings grow. We don’t need to discuss this one. But what if earnings are stagnant and consistent (consistent is a very huge assumption, I’ll discuss why this is the case in the dangers section)? Example: Company X earns $100/year. They will only earn $100/year for….ever. Would they become more “valuable” every year???
Answer: Yes! Based on the formula we saw above, they’d gain in value $100/year. After the first year they’d make $100 more in cash, they’d do it again the next year, and the next.
How investors profit from this
Investors profit tangibly from buy and hold in the form of dividends. The most intuitive model would be if a company paid out 100% of their earnings as dividends. Then if you owned Company X you’d get the $100 every year, basically making your investment in Company X richer by $100 every year. But usually companies do not pay all of their earnings out as dividends either because they want to accumulate cash or reinvest it back into the business. But even in this case, the investment in Company X is still increasing in value because cash is increasing (and remember the formula $100*P/E + Cash). I think it’s the part that cash adds value to a company that’s the key bit in understanding why a company with stagnant earnings is still increasing in value every year. The cash can be used to make acquisitions/buyback shares/etc but that’s more of a discussion of capital allocation and can be discussed another time.
The dangers to buy and hold
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Earnings might decrease. This is the key and very important assumption that’s being made in all of this. If earnings are not growing or are even decreasing every year, then the company is probably not increasing in value every year (since value = earnings power (decreasing) * P/E + cash)
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Management might not manage their cash properly. Perhaps earnings are steady, but if management is constantly making poor acquisitions or even just losing the money, then they will certainly not be increasing in value every year. An investment savings account is useless if it doesn’t protect the value of your assets. When people say analyze management, you can see why capital allocation is a critical factor.
Conclusion Hopefully this helped to explain why buy and hold makes sense as an investment strategy, at least theoretically. If you already knew all of this and learned absolutely nothing new, I apologize but offer this cute dog giphy http://ift.tt/1uj5RPJ
Now we all understand why Buffett is mainly a buy and hold investor: so long as the company has consistent and growing earnings annually or over the long term, no matter what the stock price is doing, the value of his investment is growing (either from earnings power or cash or both).
As always, best of luck out there. It’s a total battlefield.
Submitted February 05, 2017 at 12:54AM by linlaoda http://ift.tt/2keNIFp
