Many investors subscribe to the "Buy and hold" philosophy of investing. Some even say that anything other than the "buy and hold" approach is not investing, but speculating. In this article, I will explain my approach to investing in high-yield stocks (SPYD)(DIV); namely, why I generally do not subscribe to the "buy and hold" approach in this sector but still consider my approach long-term oriented and investing rather than speculating.
What Is 'Buy and Hold' Investing?
Before discussing why I do not subscribe to "buy and hold" investing and what I do instead, let's first discuss what "buy and hold" investing is.
It is a long-term investment strategy where an investor buys securities - typically common stocks - assets and holds on to them for a long period of time, regardless of short-term market fluctuations. Some investors take this approach even further by resolving to never sell a stock - even if its underlying fundamentals are decaying - for a certain period of time, and in some cases, even forever. The reasoning behind this philosophy is that selling a stock disrupts the power of long-term compounding and that leaving the door open to selling at all could potentially cause your emotions to get involved, leading to irrational decision-making. Many point to numerous Warren Buffett quotes to support their thinking, especially his statements:
Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.
Our favorite holding period is forever.
This philosophy rests on the following principles:
The Power of Long-Term Compounding: "Buy and hold" investors believe that buying good companies at fair or discounted valuations and then letting time run its course will generate attractive total returns over the long run. By ignoring the short-term ticks up and down in the stock price, they avoid being led astray by their emotions and allow compounding to continue doing its work. Some great examples of this are Blackstone (BX), Main Street Capital (MAIN), and Realty Income (O), as numerous times over their prestigious publicly traded careers, these stocks have looked quite overvalued and have also crashed quite hard during market panics. Yet, those who have held for many years have enjoyed total returns that have totally crushed those generated by the S&P 500 (SPY). As Warren Buffett put it: "You only have to do a very few things right in your life so long as you don't do too many things wrong."
Minimizing Frictional Costs: "Buy and hold" investors also believe that buying and selling stocks erodes long-term returns because of the frictional costs involved. While the elimination of most brokerage transaction fees greatly reduces the argument against frequent trading, there are still bid/ask spreads (though in many cases, these are extremely small too) and - perhaps more importantly - capital gains taxes that erode long-term total returns. This viewpoint is once again held by Mr. Buffett due to his conviction that the number of available truly wonderful businesses is quite small on a relative basis and that once you get to buy one at a fair or discounted price, it makes little sense to sell it purely for purposes of valuation if in the process you get penalized with having to pay substantial capital gains taxes. As he stated: "If you own a wonderful business...the best thing to do is keep it. All you're going to do is trade your wonderful business for a whole bunch of cash, which isn't as good as the business, and you have the problem of investing in other businesses, and you probably paid a tax in between. So my advice to anybody who owns a wonderful business is keep it."
If It Ain't Broke, Don't Fix It: Many "buy and hold" investors who choose to invest in high-yielding stocks do so because they don't care so much about generating market-beating total returns, but rather about generating a lucrative passive income stream. As a result, they care little about selling a stock - regardless of its valuation - as long as it continues to throw off a generous amount of cash flow via dividends. This sentiment is expressed often by investors in Business Development Companies (BIZD) like Ares Capital (ARCC) and Blackstone Secured Lending Fund (BXSL), which - despite presently trading at considerable valuation premiums relative to their historical averages - still offer very attractive and pretty safe dividends. In other words, if the stock is doing what you bought it to do, why sell it? As Mr. Buffett once said: "We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a 'romantic'."
Why I Do Not 'Buy and Hold' High-Yield Stocks
While these are certainly some very compelling reasons to adopt the "buy and hold" approach to investing - and I do believe they hold for investing in many types of businesses - I do not apply this strategy when investing in the vast majority of high-yield stocks. Here is why:
First and foremost, most high-yield stocks intrinsically do not meet Buffett's definition of a truly wonderful business. Warren Buffett once explained that:
The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.
His reasoning for this is pretty clear-cut: (1) such businesses can compound wealth internally for long periods of time and therefore are very difficult to fully value since they can generate value at much higher rates than the stock market's long-term average rate of return, and (2) investors effectively get tax-deferred compounding by investing in these businesses since they do not have to pay taxes on dividends and/or through selling the business once it is fully valued since it is hard to know when these sorts of businesses are fully valued due to their ability to compound retained cash flow at high rates of return.
In contrast, businesses only pay out high yields via dividends and buybacks because they lack a sufficient number of high-returning places to allocate that capital internally. As a result, they are generally not great wealth compounders over the long term, barring exceptionally supportive macro tailwinds such as extremely low interest rates or specifically strong industry dynamics (aka soaring oil demand/prices for a high-yield energy company like Exxon Mobil (XOM) or soaring ore prices for a miner like Rio Tinto (RIO)). Yes, there are some exceptions to this and management quality does make a difference here regardless of industry, but the general principle holds, and typically those long-term outperformers have only achieved that track record because they have leaned successfully into very supportive macro factors and have avoided making any disastrous errors when deploying capital.
Sure, many of these businesses do reinvest some of their retained capital into double-digit return opportunities, and you see this in the returns on invested capital that they generate. Enterprise Products Partners (EPD) is a great example of this. However, they typically only invest a relatively small percentage of their retained cash flow in these opportunities and their existing assets typically generate limited growth over time. As a result, their annualized per unit/share intrinsic value growth rate is typically constrained to the low to mid-single digits.
This means that buying and holding these stocks will likely generate between 10-12% long-term total return CAGRs, assuming no grave mistakes are made and nothing too disruptive crosses the path of the business. This is about what you can expect from the broader stock market over the long term as well, so there is certainly nothing wrong with this approach. However, it also means that an investor is highly unlikely to outperform by any meaningful margin over the long term. For investors who are income-focused and want decent long-term total returns but are not overly concerned with beating or even matching the total returns of the market, this is a fine approach.
How I Invest In High-Yield Stocks
However, given that I am in my mid-30s, I am still very much focused on total returns. You may then ask: "Why don't you just invest in high-growth tech stocks and ignore high yield until you get closer to retirement?" That is certainly a valid point, and if I didn't research stocks full-time, I would seriously consider that approach.
However, I have chosen to invest in high-yielding stocks because it is their very nature to slow-growing, stable cash-flowing businesses that pay out high dividend yields such as midstreams (AMLP), REITs (VNQ), utilities (XLU), and BDCs, that makes them generally much easier to value than growth stocks like Palantir (PLTR) given that their growth rates are much more predictable many years out into the future. With a narrower definition of possible net present value for these sorts of stocks, I believe it is also much easier to manipulate Mr. Market's moodiness and thereby generate long-term outperformance through the sector even if the average high-yielding stock may underperform the average growth or dividend growth stock.
How do I do this? I deploy an opportunistic capital recycling strategy with high-yield stocks rather than merely buying and holding them because when I am selling a high-yield stock I know that I am not forfeiting a powerful long-term compounder since they are typically unlikely to grow their intrinsic values at a rapid pace each year. As a result, if I sell a stock that only yields 5% in order to recycle the capital into another defensive stock that offers a 7% yield with a similar growth potential, I can still generate very attractive total returns. This is because the 7% yielder that is otherwise comparable to the 5% yielder that I just sold in terms of quality and growth potential could very possibly see a 20-40% increase in its valuation multiple on top of the steady 10-12% yield plus growth total return in the coming few years in order to bring its valuation to be in-line with its more richly valued peer. Sure, I will not win with every trade, but if I am right more often than I am wrong, I can generate significant alpha relative to the broader market by implementing this strategy.
Investor Takeaway
Ultimately, my approach boils down to the principle that with quality high-yield stocks, there are far fewer unknowns, and therefore it is much easier to behave intelligently (like an investor). Of course, investing in high-yield stocks is still far from a slam dunk, which is why I have a four-part filter that I apply to high-yield stocks that I purchase. However, this approach to actively managing my portfolio through opportunistic capital recycling has worked extremely well for me over the long term, contributing to my total returns more than doubling those of the high-yield space and significantly exceeding even those of the S&P 500 (SPY).
Buying and holding quality high-yield stocks or even some good high-yielding ETFs is not a bad approach to funding retirement, and is certainly easier than actively managing a portfolio. However, by recognizing the differences between long-term compounding machines and high-yield stocks, an investor focused on maximizing long-term total returns can successfully embark on one of two promising paths to potentially achieving alpha over the long term. Otherwise, confusing the two may lead to disappointing outcomes as an investor may end up selling an Nvidia (NVDA) way too soon or holding a slow-growing REIT for far too long, only to watch it ping back and forth within a narrow range for years while earning nothing but the 7% dividend that it throws off.
As a final aside, I would also add that given the tax ramifications of investing in stocks that pay substantial dividends as well as from active portfolio management, I personally hold all but the K-1 issuing and foreign tax withholding stocks in my IRA/401k. Meanwhile, I hold my K-1 issuers, foreign tax withholders, and growth stocks and ETFs that I buy and hold for the long term in my taxable accounts. Of course, this is not tax advice, but it has been a helpful practice for me.
If you want full access to our Portfolio which has beaten the market since inception and all our current Top Picks, join us for a 2-week free trial at High Yield Investor.
We are the fastest-growing high yield-seeking investment service on Seeking Alpha, with ~1,200 members on board and a perfect 5/5 rating from 166 reviews.
Our members are profiting from our high-yielding strategies, and you can join them today at a compelling value.
With the 2-week free trial, you have nothing to lose and everything to gain.
Start Your 2-Week Free Trial Today!
