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There are at least three reasons why a buy and hold strategy (i.e., the purchase of part-ownership of good businesses at bargain prices, and the retention of these holdings as long as these businesses remain sound, thus achieving returns commensurate with their underlying business operations), despite the disapprobation heaped upon it recently, remains a sensible course of action
Justification #1: Trading Is a Loser’s Game
One justification of a buy and hold approach to investment (as defined in Part II) is that its antithesis, speculative trading, leads almost inevitably to tears. Speculators regard a security (i.e., a stock, bond or title to real estate) as a piece of paper and consider its intrinsic value and market price to be synonyms. They focus almost exclusively upon “the market”; ignore the economic fundamentals of the business that underlies the security; and try to anticipate short-term price trends and fluctuations. Investors, in contrast, distinguish sharply between a security’s market price and its intrinsic value. They focus upon the economic fundamentals of the business underlying a stock or bond, and pay attention to the volatility of its price only to the extent that it enables them to buy at reasonable or bargain prices. Speculators thus tend to buy and sell in rapid succession; investors, in contrast, intend to buy and hold for the long term (five years or more). The key to successful speculation is the ability to anticipate the direction of prices and the magnitude of fluctuations around trends. If we were omniscient and able to predict short-term price fluctuations perfectly accurately, buying at a low price and selling shortly afterwards at a higher price, we would clearly make much money. It is precisely this prospect of quick, effortless and large trading profits – together with a high degree of confidence in their ability to divine the future – that tempts so many people to speculate.
As alluring as this sounds, in practice it is extraordinarily difficult if not impossible to time one’s speculative purchases and sales to the standard of precision required in order to generate results that exceed those achieved by the buy and hold investor. Three simple examples, described in a circular entitled Why Speculation Inevitably Ends in Tears, show us why. How do a speculator’s results compare to the buy and hold investor’s? To answer this question we need to make several assumptions. The assumptions in the circular load the dice extraordinarily heavily in the speculator’s favour. But no matter: in 4 of the 6 scenarios the “dumb” buy and hold investor beats at least one (and sometimes both) of the extremely smart, very accurate but imperfectly omniscient speculators.
Justification #2: Reduced Transaction Costs
Whether they are private individuals or major institutions, few market participants seem to resist the temptation constantly to buy and sell securities. They feel the need to “churn” (i.e., to buy and sell within short periods of time) rather than wait for attractive opportunities to buy and hold. During the period 1 January-9 August 2002, for example, approximately 4,414 million shares of Telstra Corp. Ltd, one of Australia’s largest listed companies, changed hands. If this trading continues at the same frenetic rate for the rest of 2002, then 7,062 million shares will be exchanged. The total number of shares on issue is 12,866 million. Accordingly, at present rates 55% of Telstra’s shares will change hands this calendar year. And when one considers that the Commonwealth Parliament owns slightly more than 50% of the shares, churn as a percentage of “free float” rises to approximately 110%. On an annualised basis, in other words, each tradeable share of Telstra will be exchanged 1.1 times during calendar 2002. Churn rates for major companies and major institutional portfolios in the U.S. are often far higher. According to figures compiled by Timothy Vick, on an annualised (2000) basis each share of Compaq Computer changed hands 2.6 times. Corresponding turnover for Dell Computer was 2.9 times, America Online 4.9 times, and Yahoo! – brace yourself – 10.8 times. Churning is costly. On each side of the transaction brokers (or “croupiers” as
Charles Munger, Mr Buffett’s Vice-Chairman, has called them) extract a commission. Mr Buffett has estimated that the sum of all commissions, fees, etc. generated by churning is vast. In his words, “my estimate is that investors in American stocks pay out well over $100 billion a year – say, $130 billion – to move around on those chairs or to buy advice as to whether they should! Perhaps $100 billion of that relates to the FORTUNE 500. In other words, investors are dissipating almost a third of everything that the FORTUNE 500 is earning for them by handing it over to various types of chair-changing and chair-advisory ‘helpers’ … In my view, that’s slim pickings.”
Many Australian unit trusts generate turnover ratios of 50-60% per year, and in recent years their American counterparts have churned between 100% and 200 % of their portfolios each year. In a review of 3,560 American unit trusts (“mutual funds”), Morningstar, a Chicago-based researcher, discovered that funds with low turnover ratios generated better results than those with higher turnover ratios. Over a ten-year period, funds with turnover ratios of less than 20 per cent achieved returns that were approximately 14 per cent higher than funds with turnover rates of more than 100 percent (The New York Times 21 November 1997).
Churning is also costly in a more general sense. It is not sufficiently recognised – but is nonetheless fundamentally important to understand – that the more frequently one trades the poorer one’s results. This point applies as much to major institutions as it does to day traders. Clearly, the greater the frequency of trading the greater the amount paid in commissions. Accordingly, the more frequently one trades the more profitable one’s trades must be in order to counteract the drag imposed by commissions and other charges. Hence a result demonstrated most convincingly in an article by Terrence Odean and Brad Barber entitled Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.
Robert Hagstrom, borrowing from Berkshire Hathaway’s 1996 Annual Report, wrote in The Warren Buffett Portfolio (John Wiley & Sons, 2000, ISBN: 0471392642) “when carried out capably, a [low turnover, buy and hold] investment strategy will often result in its practitioner owning a few securities that will come to represent a very large proportion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20 per cent of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.”
Justification #3: Enhanced After-Tax Results
A Grahamite buy and hold approach to investment has another important advantage: it postpones capital gains tax (CGT). Except in the case of non-taxable accounts, taxes are the biggest expense that investors face. When a stock appreciates in price but is not sold, the increase in value is unrealised gain. No CGT is owed until the capital gain is realised, i.e., the asset is sold. Clearly, if the gain is left in place then capital compounds more quickly. Investors have too often underestimated the enormous value of this unrealised gain – what Mr Buffett has called an “interest-free loan from the Treasury.” To see this, consider as a Buffett-inspired thought experiment that we have $100 to invest; that we invest it in a security whose intrinsic value compounds at a rate of 15% per year and whose market price, by some miracle, always corresponds to its intrinsic value. Assume for simplicity that capital gains tax (CGT) is levied at a rate of 15%; that (more miracles) there are no brokerage fees; and that the security’s initial purchase price is $1.00 per share. If we sold the security one year after we bought it then we would have an after-tax gain of $0.105 per share and total investment capital of $110.50. If we used this capital immediately to repurchase the security at $1.15 per share, held these shares for a year, sold them, paid CGT, and repurchased every year, then after 10 years we would accumulate 70 shares, pay CGT of $73, pocket $271 and earn a compound rate of return of 10.1% per annum. If we paid brokerage fees of just 0.5% per transaction then after 10 years we would accumulate fewer (64) shares, pocket a lesser amount, $245, and earn a lower compound return of 9.0% per annum. If, on the other hand, we purchase 100 shares at $1.00 per share, hold them for 10 years (thereby delaying CGT and brokerage fees) and sell them at the end of the tenth year, then we would pay more ($92) in taxes – but also pocket more cash ($313) and increase the compound rate of return to 11.9% per annum.
Buying and Holding in the 21st Century
A buy and hold strategy (i.e., the purchase of part-ownership of good businesses at bargain prices, and the retention of these holdings as long as these businesses remain solid, thus achieving returns commensurate with their underlying business operations) has served Leithner & Co. well and remains at the core of its investment operations. Even when one loads the dice very heavily in speculators’ favour and attributes to them superhuman prescience, speculative errors of even small magnitudes lead to results which are often well below those achieved by buying-and-holding. If we accept that people are incapable of consistently timing their purchases successfully then we must conclude that poor results – and potentially large losses – are a virtually inevitable consequence of speculation. To buy sensibly and hold, then, is to reduce greatly both the probability of speculative loss and the extent of transaction costs.
These advantages are so simple and obvious – and in the interests of investors rather than advisors and funds managers – that they are easily overlooked. Trading, whether or not it is successful, implies brokerage costs; and successful speculation implies hefty capital gains taxes. Each of these imposts attenuates one’s results. In sharp contrast, “it sounds like premarital counselling advice, namely, to try to build a portfolio that you can live with for a long, long time” (Robert Jeffrey and Robert Arnott, “Is Your Alpha Big Enough to Cover Its Taxes?” Journal of Portfolio Management, 1993). Leithner & Co. has neither the talent nor the disposition to churn securities in anticipation of favourable short-term movements of their market prices. Given the benefits of the buy and hold approach, properly defined, it makes sense to devote considerable amounts of time and energy to the identification of sound securities. And given the costs of “churn” it makes sense to regard volatile market prices not as signals to trade but rather as opportunities to acquire part-ownership of sound businesses at bargain prices. Accordingly, with respect to the frequency of buying and selling (as opposed to the intensity of research) lethargy bordering upon sloth forms a cornerstone of a sensible approach to investment.
That is why, notwithstanding the recent criticisms by prominent journalists and market participants in prominent publications, it is important keep uppermost in mind the admonition of Benjamin Graham and David Dodd: “in our experience and observation, extending over 50 years, we have not known a single person who has consistently or lastingly made money by ‘following the market.’ We do not hesitate to declare that this approach is as fallacious as it is popular.”
 
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