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It is a common fallacy that most value investors are inherently buy-and-hold types who rarely turn over their portfolios. The misconception has been reinforced by a Buffett quote which suggests that his favorite holding period is forever.
Certainly, if one is fortunate enough to find and purchase a premium business such as See's Candy, which throws piles of cash while requiring little in the way of capital investment; a life-long holding period would appear to make perfect sense (more on that later). However, relatively few businesses feature such a durable moat and the portfolio of the typical investor frequently contains a number of very average businesses. These average businesses can represent outstanding values when they are purchased at favorable prices during periods of excessive market pessimism or when their earnings are experiencing a temporary downturn.
The classic value investor which we will refer to hence forth as a "Grahamite" is actively engaged in uncovering discounted stocks which provide him/her not only with the possibility of capital appreciation but also a sufficient margin of safety. By definition, the investor's margin of safety in an equity slowly erodes as its stock price appreciates; therefore the Grahamite has little choice other than to sell his stock once it has appreciated beyond its perceived value.
Holding a stock once it becomes fully valued is tantamount to speculation. If the stock moves quickly to its perceived fair value, then the process of the the Grahamite mirrors the process of a short-term trader, although his decision is always based upon valuation metrics. Therein lies the paradox of classic value investing. In the strictest sense, a Grahamite must be an active stock trader unless his investments never approach their perceived value. If that is the case, then the so-called value investor is probably woefully deficient in his stock-selection acumen and would be better served by purchasing index funds.
Buy and Hold Relies on Growth
In the past few decades the dichotomy between value investing and growth investing has become blurred. Buffett and Munger have been instrumental in blurring the traditional separation by incorporating the concepts of return on capital and durable competitive advantage into the lexicon of value investing. To paraphrase, the rallying cry has been we would rather buy a great business at fair price than a fair business at a great price.
Successful buy-and-hold investing requires two distinct elements:
1) The business must have a legitimate long-term competitive advantage.
2) The business most possess the ability to grow earnings on a long-term basis.
Imagine that I own a bar directly adjacent to Wrigley Field. Without a doubt my business holds a durable competitive advantage in regard to most other "water holes" in Chicago. Does that mean that I should never sell the business? Since the business offers limited growth potential the answer is maybe yes, maybe no; it all depends upon the offering price I receive.
On the other hand, suppose I own a small chain of bagel and coffee shops in Nebraska which are successful without regard to a specific location. Every new shop I open attains roughly the same level of profitability, returning about 20% on invested capital. In such a case it makes no sense to sell the business chain. The offering price is irrelevant. Where could one find an alternative investment which would grow returns at such a high rate?
Both businesses had significant competitive advantages, but the bagel shops had extreme growth potential. Therefore, the latter investment is a buy-and-hold proposition.
Classic Value Investing Buys and Sells Average Businesses
Grahamites are not so interested in purchasing premium businesses with superior growth prospects; rather, they are interested in purchasing discounted businesses with the aim of selling their shares when the undervalued company appreciates to its fair value.
In the interim, the Grahamite is perfectly willing to accept the dividend payments which a company offers. However, the dividend payment alone should never become the basis of the investors holding period. Just as the quote from Templeton suggests at the beginning of the article, value investors should always be willing to exchange shares in one stock for another which represents a better bargain.
Low-growth and low-ROC companies are the bread and butter of Grahamites, particularly if they trade at large discounts to tangible book value. Such businesses contain little in the way of durable competitive advantages. Therefore, holding them beyond their fair value makes little sense.
Furthermore, companies which hold little in the way of a competitive advantage realize no additional shareholder value when they attempt to grow their businesses. Instead, they merely trade a dollar of shareholder capital in exchange for a dollar of additional growth. To paraphrase Buffett, in such cases the growth of the business takes precedence over the best interests of the shareholders.
Buffett and Coke (KO)
Buffett is sometimes accused of holding investments and businesses too long. Sometimes the criticism is warranted, although the tax implications of selling such high cash-generating businesses frequently overrides the status of their growth. Certainly the lack of growth in See's Candy would seem to warrant a sale at some point if the offering price was sufficient. It seems that Berkshire Hathaway (BRK.A)(BRK.B) is no longer interested in growing the sales of the legendary confectioner. Many believe that See's could be developed in national rather than a regional brand if their management so desired.
Most serious investors are privy to Buffett's outstanding purchase of KO shares several decades ago. His 2011 annual letter reveals that his investment has appreciated approximately 11-fold while supplying Berkshire with hundreds of millions of dollars in additional dividends. Everyone should be so fortunate to have a similar investment in their lifetime.
All that said, does KO currently represent a prudent buy-and-hold proposition based on its current valuation? Or would investors be better served to invest their money elsewhere?
KO Growth and Valuations
No one would deny that KO owns a valuable franchise with a legitimate durable competitive advantage; the question remains whether the future growth of the company can justify its current multiple. Bear in mind that the larger a company becomes the more difficult it becomes to maintain high growth rates. With that in mind let's take a quick look at the valuation metrics for KO.
According to GuruFocus' 10-Y financials, KO has grown its revenues per share at a CAGR of 9.2% and currently trades at a trailing price to sales ratio of 3.8 times its market capitalization. The growth rate is illuminating; however, the P/S ratio is meaningless when viewed independently of a company’s operating margins.
P/S ratios must be viewed in the context of operating margins to yield any beneficial information. In other words, a high P/S ratio is perfectly fine so long as the business commands a sufficiently high operating margin. Low P/S ratios are typical of low-margin companies which possess little in the way of competitive advantages. That said, companies with high P/S ratios and only mediocre historical operating margins or operating margins that are steadily declining should generally be avoided. Here are the average P/S ratios for KO over the past ten years.
INDUSTRY: Beverages - Soft Drinks
| AVG P/E | PRICE/ SALES | PRICE/ BOOK | NET PROFIT MARGIN (%) | |
|---|---|---|---|---|
| 12/11 | 18.1 | 3.49 | 5.01 | 18.4 |
| 12/10 | 11.2 | 4.37 | 4.86 | 33.6 |
| 12/09 | 16.7 | 4.28 | 5.29 | 22 |
| 12/08 | 21.6 | 3.31 | 5.11 | 18.2 |
| 12/07 | 21 | 4.96 | 6.54 | 20.7 |
| 12/06 | 20.3 | 4.71 | 6.61 | 21.1 |
| 12/05 | 21 | 4.18 | 5.84 | 21.1 |
| 12/04 | 23.3 | 4.65 | 6.3 | 22.3 |
| 12/03 | 25 | 5.99 | 8.79 | 20.8 |
| 12/02 | 31.1 | 5.56 | 9.18 | 20.3 |
During that period KO had operating margins that ranged from a high of about 28% in 2002 to a low of about 22 % in 2011. The steady downward trend in operating margins is troubling in light of Coke's high P/S ratio.
KO has averaged about $2.42 per share in free cash flow for the trailing 10 years, with per-share CAGR of 6.5%. The stock currently trades at over 26 times trailing free cash flow. In the last several years the free cash flow of the business has not come close to matching its accrual earnings.
If we use accrual earnings instead of FCF, the trailing PE of KO is about 20 times its market cap. Using EV/EBITDA, KO currently trades at about 14.7x, compared to about 17.2x at the close of 2002. Almost 15 times EBITDA is quite expensive for a company which is growing sales at a rate of less than 10% of its cyclically adjusted average (10 years).
In the last year KO has appreciated to a level near its all-time high which it recorded in the late 1990s while growing its dividend from $0.80 in 2002 to its current level $1.88 per share. In reality, the dividend is all that investors have captured in approximately the last 15 years unless they purchased the stock in late 2008 or early 2009 when it fell to its most favorable valuation.
Such is the peril of buying blue chip stocks at inflated prices even if they have enormous moats.
Conclusion
It is a common fallacy that value investing requires a buy-and-hold mentality. Buy-and-hold investing is only suitable for companies which have strong durable competitive advantages and are likely to grow their earnings at a suitable rate for the foreseeable future.
On the other hand, Grahamites are actively engaged in seeking out and purchasing averaged companies which are temporarily undervalued. To be successful in the long term, it is incumbent upon the Grahamite to sell these average companies when they approach or exceed their fair value.
The process appears akin to the trading activities of a market speculator; however, the process is based upon pricing rather than speculation.
All investors need to pay attention to the price they pay for equities. Companies which hold large competitive advantages and exhibit steady growth can be poor buy-and-hold propositions if their valuations are too rich.
Coke (KO) is a classic example of a great company which has been a poor buy-and-hold stock in the last fifteen years due to its near-terminal overvaluation.
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Once again you provide an interesting read. I hope that you don't mind if I point out that apparently Graham in fact practiced a much wider range of investment than might be obvious in his books about security analysis. It appears to me to be common for many "value investors" to argue that Buffett no longer adheres to "classic" Graham investment practice, but Buffett himself repeatedly states that he still does it the way Graham taught him to do it:
"[Graham and Dodd] laid out a roadmap for investing that I have now been following for 57 years. There's been no reason to look for another." - Warren Buffett (2009)
(I mean no disregard to comments by Buffett about Phil Fisher's influence, but IMO the real impact of Fisher's influence on Buffett has been overstated by many. AFAIK Buffett hardly ever mentions Fisher as an influence while he often refers to Graham's influence. In one interview, when pressed, Buffett said that he was 85% Graham and 15% Fisher.)
AFAIK Graham didn't limit himself to "cigar butt" investing. Nor did he eschew "growth" companies; he just was concerned about how much to pay for the future growth which he considered to be relatively uncertain. An good example might be GEICO, which Graham and his partners and investors owned for 25 years or so. Graham himself apparently said that he and his partners made more money on the GEICO investment than all their other investments together.
Regarding KO, In a Buffett interview several years ago I heard him say that with hindsight maybe he should have sold shares back in the late '90s when KO was selling at a very high price relative to its historic pricing levels. However it was complicated: Buffett's own selling activity was likely to impact the market price; after paying large capital gains taxes he would be left with the need to find a replacement investment as good or better with the after tax capital from the sale available to invest and he thought that might have been difficult. He specifically pointed out that when he considered the dividend yield as calculated based on the expected after tax value of the invested capital, it would be hard to replace.
If you haven't read it, may I suggest that the book Benjamin Graham on Value Investing by Janet Lowe might be of interest to you because IMO it provides some insight into Graham's wide ranging investment "operations" as Graham liked to call it. One of my favorite quotes in the book:
"Graham himself once said that his books: ' have probably been read and disregarded by more people than any book on finance that I know of '." William Ruane
Good luck.