Why a hold recommendation is no recommendation at all

Why a hold recommendation is no recommendation at all

David Kaufman | 13/05/24 | Last Updated: 13/05/24 3:55 PM ET
It is part of the human condition to want to classify things. In the world of finance, where many analysts suffer from what is referred to as “physics envy,” there is an inescapable draw to being able to reduce any problem, large or small, into a neat box that can be labelled with a simple word or phrase. Hence the infatuation with recommending investments as either a buy, sell or hold. If this made sense, that would be one thing. But it doesn’t. There is no such thing as a hold.

The hold recommendation on a stock, at best, gives investors mixed signals. At worst, it makes them suspicious. Either way, the go-between rating is here to stay and knowing how to read it may add considerable value to a portfolio.
The proof of this statement requires an exercise for which three assumptions are necessary. First, that the set of possible investment choices is far greater than the number of required investments. Second, that there are little or no transaction costs (whether in the form of commissions, redemption fees or taxes) that apply in moving from one investment to another. And third, that there is enough liquidity in any investment to buy and sell it without having an impact on its value.Keeping those assumptions in mind (and there are situations where they do not hold), let’s, for simplicity’s sake, say you own 10 large-cap liquid stocks in a universe of 500 stocks. Ten, you believe, is the right number to be able to add value through sound stock-picking and to provide enough diversification so that a mistake is not overly catastrophic.

Every morning you get up and survey your basket of equities. Because they are liquid and trade in high volumes, you have three choices: keep the stocks you own; sell them all; or sell some of them and either replace them with other stocks or hold cash.

What most people don’t seem to grasp is that doing nothing — keeping the 10 stocks you own — is the same as buying those 10 stocks. And if those are not the absolute best 10 stocks to own at a particular point in time, the fact that you already own them should have zero impact on how you act.

Essentially, every day, you should assume that every stock you own has already been sold and then buy back the 10 best stocks available at that time. If it’s the same 10 as before, fine. But, over time, it would be hard to believe you would have been fortunate or prescient enough to have chosen the top 10 stocks out of 500 on your very first try.

But if you’re not willing to look at your holdings this way, what’s the point of paying a premium for the liquidity that public securities offer?

An analyst goes through the same quantitative and qualitative process that an investor does in choosing which stocks to own. With the same universe of 500 stocks (and the same assumptions), the analyst should, at any given time, be able to label every stock she covers as either a buy or sell. In other words, “if you don’t own this already, you should,” or “if you do own this already, you shouldn’t.”

But we constantly see analysts coming out with hold recommendations — “if you don’t already own this then don’t buy it, but if you do then don’t sell it.”

That is sheer nonsense. Since we have already established that investors of public securities essentially repurchase their entire portfolio every day, the concept of a hold loses its meaning entirely. From this perspective, there are only stocks you should own and those you should not. End of story.

Now let’s return to the assumptions above and the shortcomings of this approach.

The first shortcoming — resulting from living in the real world where stocks are only a small part of the investing universe — is the difficulty in being able to assess the relative value of a variety of securities in real time.

It may well be that you fall out of love with, say, an investment fund that invests in mortgages, but you don’t require an immediate divorce. You might label that investment as a hold since it falls under the category that what one of my clients somewhat Kafkaesquely refers to as “repositioning.”

Similarly, if selling an investment today would subject you to a redemption fee, but selling it six months from now would not, that investment might be a hold.

In both cases, the real classification for these holds is a delayed sell.

We also don’t live in a world where all securities are liquid and transactions are free.

In the case of taxes, for example, if you are fortunate enough to have significant unrealized capital gains in a holding, you would not want to sell that holding unless you believed it was going to precipitously depreciate or if you had such a good idea that the security you were replacing it with would more than offset today’s taxes in future gains.

Similarly, if you were to hold such a large position in a security that selling it all at once would reduce its value, you might want to gradually sell it to reduce the impact of overweighting the offer on that security.

There are many cases in which you might logically label one of your own investments as a hold. But the reasons for doing so are practical and individual.

An analyst in the abstract (i.e., one who does not know your personal situation) should be able to tag every security as a buy or a sell. Labelling an investment as a hold is shirking the singular duty an analyst has.

David Kaufman is president of Westcourt Capital Corp., a portfolio manager specializing in traditional and alternative asset classes and investment strategies. He can be contacted at drk@westcourtcapital.com

 

Why some analysts see value in holds

David Pett | 13/05/24 | Last Updated: 13/05/24 3:54 PM ET
The hold recommendation on a stock, at best, gives investors mixed signals. At worst, it makes them suspicious. Either way, the go-between rating is here to stay and knowing how to read it may add considerable value to a portfolio.

It is part of the human condition to want to classify things. In the world of finance, where many analysts suffer from what is referred to as “physics envy,” there is an inescapable draw to being able to reduce any problem, large or small, into a neat box that can be labelled with a simple word or phrase. Hence the infatuation with recommending investments as either a buy, sell or hold. If this made sense, that would be one thing. But it doesn’t. There is no such thing as a hold.
“I often think I’d rather just have ‘own’ or ‘don’t own’ recommendations and do away with holds altogether,” said Murray Leith, vice-president and director of investment research at Odlum Brown Ltd. in Vancouver. “For all intents and purposes, what’s the difference between a buy and a hold? You either own the stock or you don’t.”

Of course, the hold concept is not likely to disappear anytime soon. As Mr. Leith points out, many of the bigger sell-side research firms that are also involved in the investment banking business tend to like hold ratings, because they save them from having too many sell ratings on stocks, something that may put off future clients.

“That’s the reality, so a hold is often a silent sell,” he said.

Odlum Brown isn’t involved in investment banking, but Mr. Leith believes hold ratings are more reflective of a pause in the analysis process, and can signal a buying opportunity just as often as a reason to sell.

For instance, he may downgrade a stock that has climbed close to its target price to hold from buy not because it’s really a sell, but simply because he needs more time to decide whether or not to raise the target price.

“Holds may be the stocks that drive the next 5% in the portfolio because they have the momentum,” he said. “The stocks with the most upside in my target might be stuck in the mud for a bit, so it’s often the buys that require the most patience before they pay off.”

Alternatively, he uses holds to balance out the fact that a stock may be falling despite having sound fundamentals that suggest a reversal. “We’re all human and sometimes you just want to pause before you tell people to buy the dip,” he said.

Greg Newman, a senior wealth advisor at The Newman Group, a division of ScotiaMcLeod Inc. in Toronto, said it makes sense for investors to want to replace stocks that analysts recommend as holds with ones that have buy signals on them. But there are some circumstances, he believes, where owning holds can serve investors well.

“For example, if one believes that a hold-rated stock will soon be upgraded, all else being equal, it is better to acquire the stock before the upgrade to take advantage of the lower price,” Mr. Newman said.

A second reason to stay with a hold stock is to avoid disrupting dividend income or triggering capital gains.

“If, over time, the investor will not be better off on a total return basis, after tax and dividends are considered, by replacing the stock, then keeping the hold-rated stock may be more prudent,” he said.

A third reason to own a hold, Mr. Newman added, is if it can add to a portfolio’s diversification. In particular, stocks that are higher quality, more liquid and less volatile can help lower a portfolio’s overall risk and boost returns over time despite having a hold rating at the moment.

“Often these stocks have good, long-term businesses, low payout ratios, solid dividends, good balance sheets and lower-than-market volatility,” he said. “Owning and accumulating these names while they are not market darlings, can limit risk and, over time, enhance returns.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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