The Most Important Premise Of Long-Term Investing

by: Tim McAleenan Jr.

Perhaps one of the most dangerous attributes that an individual investor can possess is the belief that he is a long-term investor when he is not one. That is not to say that a long-term investing approach is the only successful investing strategy. Rather, it is the mismatch between what an investor thinks he is and what he actually is that can be so dangerous. This is because that most folks who wrongly believe they are long-term investors reach the determination that they are not during periods when stock prices are falling to lows. One of the best ways to determine whether or not you are cut out for long-term investing is to see whether or not you agree with Peter Lynch's commentary on faith and stockpicking.

He summed up the argument quite well on page 45 of his legendary book "Beating The Street":

"Keeping the faith and stockpicking are not normally discussed in the same paragraph, but success in the latter depends on the former. You can be the world's greatest expert on balance sheets or P/E ratios, but without faith, you'll tend to believe the negative headlines. You can put your assets in a good mutual fund, but without faith you'll sell when you fear the worst, which undoubtedly will be when the prices are the lowest.

What sort of faith am I talking about? Faith that America will survive, that people will continue to get up in the morning and put their pants on one leg at a time, and that the corporations that make the pants will turn a profit for the shareholders. Faith that America is a nation of hardworking and inventive people, and that even the yuppies have gotten a bad rap for being lazy."

I think that the acceptance of this premise can serve as the source of confidence for holding (and even buying!) during times of economic distress. Buffett was able to buy American Express (AXP) in the aftermath of President Kennedy's assassination because once he could determine that the integrity of the American credit system would remain intact, he was able to blast away the fear and make a bold purchase.

Charlie Munger, the Vice Chairman of Berkshire Hathaway (BRK.A), was experiencing 31% paper losses during the bear market of 1973-1974 when he marched into the Union Bank of California and demanded $3 million so that he could invest in Caterpillar (CAT) tractors and British Columbia Power. Think about that: he was down 31% on paper, discussion of the world ending was in full vogue, and Munger was aggressively borrowing money to buy ownership stakes in businesses.

John Neff, the legendary investor who ran the Vanguard Windsor Fund from 1964 to 1995 and achieved 13.7% annual returns over that time frame, lost over half of his entire net worth during the 1973-1974 bear market. What did he keep doing with his clients' funds? He bought blue-chip stocks trading at single digit P/E ratios. The end result? The Windsor Fund returned 54.5% in 1975 and 46.4% in 1976.

Long-term investing does not suit the needs of every investor. But believing in the Lynchian premise outlined above can be powerful. What is my goal as an investor? I want to buy the highest quality businesses (often US multinationals) when the best opportunities arise and then hold those companies for the long haul. I want to be the guy buying Berkshire Hathaway (BRK.B) at $43 per share in 2008 and never looking back. I want to be the guy buying Coca-Cola (KO) at $37 and Johnson & Johnson (JNJ) at $47 per share with the attitude, "As long as these companies continue to grow, these shares aren't going anywhere. My heirs can inherit them in my estate." That's the ideal I'm pursuing.

And that's why I regularly ask myself the question: What do I need to do to make this happen? To find success, I need to accept the premise that my stock ownership will still mean something in the event of the next severe crisis. I believe that even if things in this country get really terrible, people will still be able to buy Coke from the soda machine, shop at Wal-Mart (WMT), give Tylenol to their sick kids, brush their teeth with Colgate (CL) toothpaste, and so on. Once I reach this conclusion (not nominally speaking, but really believe it), then I can summon the gumption necessary to buy these high-quality companies the next time a crisis sends these stocks to the type of valuation seen in 2009.

I think diversification can play an important role in crafting a long-term strategy that lends itself to staying the course. If half of my retirement funds hinged on the success of either BP (BP) or Johnson & Johnson, I could easily panic and sell at lows when Johnson & Johnson issues recalls or BP alerts investors to hiccups in profitability arising from the Gulf of Mexico oil spill. If the failure of either of those two firms put me at risk of diminishing my standard of living, then I would likely feel a strong impulse to sell when times got tough.

But what if I practiced widespread diversification by owning two dozen of the strongest US multinationals and six or seven powerhouse foreign stocks? Then, the knowledge that I'm receiving dividends from Pepsi (PEP), Clorox (CLX), Unilever (UL) and 20+ other firms of similar earnings quality can give me the strength to ride out the BP and Johnson & Johnson storms, ensuring that I'm not practicing the worst form of investing: Buy high, and sell lower.

The pursuit of holding stocks for extended periods of time is not suitable for every investor. But once an investor reaches the determination that a world crisis will not wipe out the companies worthy of his investment dollars, then he has a tremendous advantage over his fellow investors: he can truly engage in the practice of buying low when everyone else is selling. The best investment advice is often some variation of: Know thyself. If you can come to truly accept Peter Lynch's faith and stockpicking argument, then you are well positioned to meet the demands and vicissitudes of long-term investing.

Disclosure: I am long BP.