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5 Things To Look For In a Buy and Hold Investment

Common Traits of Good Long-Term Holdings for Your Portfolio

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Buy and Hold Investing

When looking for assets to put into a buy and hold investment portfolio, here are five things you might want to consider.

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When you are looking for a buy and hold investment that you can put in your portfolio for decades, there are a few characteristics that you should consider.  Although they can't guarantee success - in an uncertain world, nothing can - adhering to them as a checklist can help you weed out a lot of inappropriate securities or other assets that might otherwise be tempting.

1. A Good Buy and Hold Investment Should Have Consistent Profitability

The first thing a good buy and hold investment should demonstrate is a consistent history of profitability.  And not just profitability.  Growing profitability.  Earnings should be up year after year, on average, marching ever higher.  If the company is too large to grow quickly, it should return excess profits to owners through the form of cash dividends and share buy backs.  

On my personal blog, I have done several case studies of what a good buy and hold investment looks like.  Take a moment to read some of them if you are interested in how long-term increases in profitability lead to long-term increases in wealth:

Each of those businesses was a good buy and hold investment because it had strong competitive advantages that were extremely difficult for competitors to assault.  Though there were some tough times - margins were sometimes challenged by rising prices or a project misstep hurt short-term earnings - the earnings per share kept getting higher and higher, the dividends kept growing, and wealth kept building.  These were not cyclical companies that experienced growth only during good times.  Even during a recession, people still want Clorox bleach and Nestle hot chocolate; the rich still want Tiffany diamonds; coffee and cereal are still popular.

A car company, on the other hand, experiences huge bursts in profit during booms, and then often slides into horrific losses during busts.  Dividend payouts often swell, then the dividend is cut.  These are not buy and hold investments.

2. A Good Buy and Hold Investment Should Enjoy High Returns on Equity

This was so important that it deserved its own article.  As I said then, I will repeat now: The key to finding buy and hold stocks that can make you rich is to find companies that enjoy naturally high returns on equity.  All else equal, although there are a few exceptions, a business that is able to earn 20% on equity is almost always going to beat a business that can earn only 5% on equity, assuming the debt levels are prudent.

If you don't understand how return on equity works, take a moment to read this article about how the DuPont breakdown can help you analyze it.  It's one of the most basic and important concepts in finance, accounting, and investing.  

3. A Good Buy and Hold Investment Should Be Held In The Most Tax Efficient Manner Possible

Over the long-run, taxes and expenses matter.  You can often end up with several times more wealth by simply holding your buy and hold stocks in a tax shelter such as a Roth IRA and not an ordinary brokerage account.  

To illustrate this, imagine you are 18 years old.  You just graduated high school.  You decide to save $10,000 per year.  You earn 10% on your assets, of which 3% comes in the form of cash dividends.  How much money would you have after 50 years?  

If you held your stocks in a tax shelter, you would end up with $11,639,085.  If you held your stocks in a regular taxable account, you would end up with $9,909,476.  That is a difference of $1,729,609.  The reason?  Your 3% dividend yield was fully reinvested in the tax advantaged account, but you had to give 15% of it to the Federal government in a regular account (and that is ignoring state taxes - depending on where you live, you might end up with an even bigger tax bite!).  That means your compounding rates were 10% for the tax advantaged account and 9.55% for the fully taxable account.  

That 0.45% over 50 years is what resulted in 17.5% more wealth for the first investor.

And here is the kicker: Right now, we are enjoying the lowest dividend tax rates in generations.  If the dividend tax rates increase to previous levels, the results would blow apart and the tax sheltered advantage would be even larger.  Knowing where to put your assets to maximize the tax advantages is a strategy called asset placement.

4. A Good Buy and Hold Investment Is Conservatively Financed

Recessions, depressions, contractions, and panics happen.  When they do, the first companies to go bust are those with weak balance sheets.  Great businesses have been wiped out, or nearly wiped out, by toxic balance sheets.  Many profitable banks were obliterated in the Great Recession because they held too many bad assets, and then leveraged those assets to magnify returns.  When things started to fall apart, the equity went up in smoke.

You want businesses or other assets that don't have a lot of debt - and if they do, it should be financed on a long-term, fixed rate basis.  You want businesses that have plenty of cash sitting around in the bank.  You want businesses that have lots of assets that can be drained or sold to get through the hard times.  You never want to find yourself in the position of owning a buy and hold investment that requires everything to go right to survive.  That is a recipe for disaster.

5. A Good Buy and Hold Investment Must Be Reasonably Priced When Acquired

The price you pay for an investment matters.  Look at this example I once wrote about using Wal-Mart Stores, pulled from real life data that demonstrates the concept so well.  A business like Coca-Cola can be a great buy and hold investment if acquired at 8x earnings and a horrible buy and hold investment when acquired at 70x earnings.  

Although it isn't foolproof, one quick test is to compare the earnings yield on your stock with the long-term yield on U.S. Treasury bonds.  You have a better chance of doing decently if the stock has at least the same earnings yield as the government bond, and if there is a rich cash dividend that can help support the price.  If the earnings yield of a business you are acquiring dips below the Treasury bond yield, you better be absolutely certain that the growth you think is inevitable will actually materialize.  Otherwise, you're going to be in for some unpleasant times.

Another trick is to only consider buying stocks that fit all of these criteria and have a dividend adjusted PEG ratio of 1.00 or less.

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