Monday, September 15, 2008

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 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, 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.