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Mourning Buy and Hold

So many memorable goodbyes this year.

Tim Russert, Charlton Heston, William Buckley, Jr., Don LaFontaine -- all good men for whom America mourns. We witnessed the demise of the legendary investment banks Lehman Brothers and Bear Stearns. And we may also have observed the casualty of the buy-and-hold investing philosophy.

According to CNBC pundit Jeff Macke, buy-and-hold "seems cute, and it's a nice way to sell mutual funds," but "it's not going to make you any money." One of his cohorts argued that even Warren Buffett has abandoned the philosophy that made him rich, and is "play[ing] Burlington Northern (NYSE: BNI  ) like a fiddle."

If Warren's out, what hope is there for us?
But wait a minute -- are the prospects for buy-and-hold investing really as grim as Macke claims? I don't think so -- and I certainly don't think Buffett's dabbling in Burlington Northern options is evidence that he's thrown in the towel.

Buffett's reputation has largely been built on his practice of buying and holding companies for decades with the intention of holding them forever. But over the years, he has made it clear that he's not afraid to part with a company whose business has changed for the worse.

In fact, until 2001, Berkshire Hathaway was one of the largest shareholders of Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) . However, Buffett sold this huge stake when he perceived that their assets were becoming too risky for his taste.

Mr. Macke's error lies in his assumption that buy-and-hold investors indiscriminately hold companies forever, even when it's clear they've weakened or have fundamentally changed.

Those who have indiscriminately held companies like Sprint Nextel (NYSE: S  ) and General Motors (NYSE: GM  ) over the last 10 years can speak to the pain of such a strategy, as their stocks have netted them annualized losses of more than 20% during that decade.

But true buy-and-hold investors like Buffett don't hold companies indiscriminately. In fact, their long-term success relies on two particular strategies.

Getting the goods
First, the long-term investor continually determines whether or not his company is increasing its cash flows, widening its moat, and making smart investments in future growth. If the company seems to be permanently losing its competitive edge -- as happened to GM during the last decade -- the savvy investor would sell, even if the intent had been to hold the company forever.

The second, and I would argue most important, strategy for successful buy-and-hold investing is to find the right companies to buy and hold in the first place.

The right companies
Companies you want to own forever have three factors in common:

  1. A great manager/management team with shareholder-friendly communications and a long-term focus in making business decisions.
  2. A wide economic moat that inhibits competitors from snagging customers, or which enables the company to charge a premium for its goods or services.
  3. A margin of safety in the stock price, so that investors are buying companies at a discount to their intrinsic value.

Buying companies with those characteristics is how Berkshire Hathaway -- which also currently meets all three characteristics -- has earned its outstanding annualized returns.

But Berkshire Hathaway is locked out of the most lucrative companies with these characteristics -- because if you're looking for the most outsized compounded returns on your investment dollars, your best bet is to look in the direction of small-cap stocks.

The right size
As my Foolish colleague Rex Moore explains, it's difficult to find 10-bagger stocks among large-caps simply because their size presents a barrier. For a stock like ExxonMobil (NYSE: XOM  ) to become a 10-bagger, its market cap would have to reach $4 trillion -- more than China's 2007 nominal gross domestic product! It's possible, but not likely anytime soon. Small-caps, on the other hand, face less of a headwind to long-term high-growth.

What's more, as Tim Hanson reveals, the best stocks of the past decade were all ignored by analysts, obscure, and, most importantly, small -- companies like Motley Fool Hidden Gems recommendation Otter Tail (Nasdaq: OTTR  ) , an under-followed $800 million company that began as a small Midwestern utility company, which is using its consistent stream of energy income to invest in an assortment of other businesses, from plastics to dehydrated potato products. Companies like this are the right stocks to buy and hold.

The Foolish bottom line
Buy-and-hold isn't dead -- it's just waiting out the bear market with the rest of the world's investing strategies. Investors who buy companies with strong management and sustainable competitive advantages at discount prices and hold them for the long term will see the fruits of that strategy -- just as they have after every other bear market.

And investors who dip into the small-cap universe to look for those companies have the opportunity for even greater profits.

If you're looking for more small-cap companies you could hold forever -- or at least for a very long time -- and earn a substantial profit in doing so, you can see all of our Hidden Gems research and recommendations free for 30 days. Just click here to get started -- there's no obligation to subscribe.

Adam J. Wiederman owns shares of Berkshire Hathaway, but of no other companies mentioned above. The Motley Fool also owns shares of Berkshire Hathaway, which is an Motley Fool Inside Value and Stock Advisor recommendation. Sprint Nextel is also an Inside Value recommendation. Otter Tail is a Hidden Gems recommendation. The Motley Fool's disclosure policy is long buy-and-hold investing.

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