The Perils of Long-Term Investing

The following commentary is extracted from a special report sent to subscribers of the Forbes Special Situation Survey.

Lehman Brothers (LEH) was selling for more than $85 per share in early 2007. American International Group (AIG) was around $70. Both companies were thought to be among the bluest of the blue chips. So much so, that Dow Jones even added AIG to its prestigious Industrial Average in April 2004. Yet over the course of just a few short months, both Lehman and AIG have been decimated. Lehman is now a penny stock seeking bankruptcy protection. AIG is scrambling to stay alive.

Yet Lehman and AIG are not the only “great” long-term investments that have since collapsed. For years, General Motors (GM), Ford, Fannie Mae, and Freddie Mac were included in almost all long-term oriented portfolios. Fannie Mae, for example, generated a 25% annualized return for the 20 years ending in 2000—and that does not include dividends. Unfortunately, those who bought the stock back then and are still holding it, are now sitting on a loss. As impossible as it is to believe, Fannie Mae is worth less today than it was even 30 years ago!

Warren Buffett is clearly one of the greatest investors of all time. He is famous for avoiding risk and for having a long-term buy-and-hold orientation. Like Buffett, many investment professionals are also convinced that buy-and-hold is the best way to go. Yet recent events should make all investors question this advice. Buying, after all, is just half the story. Successful investing also requires selling. And despite his reputation, even Buffett engages in short-term trades from time to time. PetroChina and Pier 1 Imports provide just two recent examples.

There is no doubt that a buy-and-hold approach can be profitable. After all, those who buy and rarely sell minimize trading costs. They also minimize taxes because, if they do not sell, they do not realize their gains. However, I have seen too many investors get burned by holding onto a stock too long simply because they wanted to avoid paying taxes. Recent events should convince even the most diehard buy-and-holders that sometimes there is fate worse than taxes. (But, of course, not worse than death.)

It is extremely important to keep an eye on intrinsic value. If a stock is no longer undervalued, it makes little sense to keep holding it. In hindsight, I have gotten out of many positions much too soon. However, I would rather move on to a stock I believe is undervalued than take the risk of holding on to one that is becoming overvalued.

Comments

[Chris B:]

Pointing to a few failed companies that have been on the market for decades does not invalidate the buy-and-hold approach. In fact, short-term traders can fall victim to the next earnings miss, disaster, broad market move, scandal, or news release - all factors that can be smoothed out by a long term approach.

Perhaps a better way to evaluate whether to sell a company is to ask the following questions:

Does the current valuation leave room for significant upside (P/E in the 20's?)?

Does the company's product/service make economic sense for its customers (buying or insuring low yielding, high risk mortgages?)?

What risks does the investment face (housing bubble?)?

Are there options with better risk / reward characteristics (usually yes)?

2008 Sep 17 03:21 PM

[bigmoney:]

Many investors are holding S&P 500, or some other market cap index fund. I am not sure how often they re-balance, but I think its annually. I doubt there is very many true buy & holder's. Even so, most investors lack the training, time, energy, and access to information to dump the losers in a timely manner, so the buy & hold (via mutual fund) is the best they can do.

2008 Sep 17 03:42 PM

[Joe V:]

Well, it looks like you've incurred the ire of die-hard LTBH-ers :) I enjoyed the article. The most compelling part was the last paragraph, about the importance of monitoring the price/value relationship.

I don't intentionally short-term trade. I concentrate on fundamentals, not price action, so my actions tend to move at a "quarterly", not daily, pace. But everything I own is for sale <b>every day</b> if the price offered allows no more room for outsized returns relative to estimated value. Long-term, short-term, it doesn't matter. Concentrate on price vs. value and the term takes care of itself.

2008 Sep 17 07:58 PM

[carey_jim:]

With hindsight, it is clear to everyone that America had an open playing field after World War II. Our enemies lay bloodied and nearly annihilated, at our feet and our own country was almost untouched while Russia, our major competitor, had lost at least 10 million men and as many civilians.

Europe, Russia, China and Japan were decimated economically, militarily and morally.

From 1945 to the collapse of the Soviet Union and the opening of China, we have led the world economically, politically and militarily.

It doesn't take a "rocket scientist" to figure out why long term investing was a the best strategy during such an unprecedented time of political, economic and military preeminence for the United States.

It shouldn't be too hard to see that things have changed and that the old rules no longer apply. It should be obvious, shouldn't it?

2008 Sep 18 11:16 AM

[notsosmart:]

carey_jim,fine point.this is now a very different fast moving world.wall st is vegas.all those charts,graphs,maps of the past should be almost ignored.the valueless paper that was recently created & now infects the world was not around for all this history.i hold good dividend paying cos.when the div. is cut im out.

2008 Sep 18 01:14 PM

[Chris B:]

carey_jim,
Good points on the geopolitics. We now have capitalistic Europe, China, and India to compete with. In such an environment, will our currency have the luxury of being the only game in town? Will we be able to exponentially increase debt forever without suffering inflation / devaluation / currency crisis? I suspect not. Maybe that's why Warren Buffet has predicted mid-single-digit returns for the next 20 years.

joe,
You're generally right about value and willingness to sell at a certain price, but if that moves you in and out of stocks quarterly, I have to wonder how things are so volatile in your portfolio.

2008 Sep 19 12:34 PM