You've just endured the third worst year in the 102-year history of the Dow and the 51-year history of the S&P 500. I'm sure you knew things were bad, but let me give you some hard facts to back up what you're feeling right now.

Half of the S&P's 10 worst trading days since 1950 happened in 2008. Half! Being down 38% in a year is painful any way you cut it -- but the sheer volatility is making mincemeat out of our emotions.

Yet, despite the turmoil, you're still reading about stocks that interest you, and hopefully investing more money in the best of the bunch. You do so not out of some perverse masochistic impulse, but because it makes sense. You know that when stocks go on sale, it's time to cash in on those market panic coupons and go shopping.

We've seen this before ... almost
The only year that comes close to rivaling the precipitous drops in recent memory was 1987. That year stakes its claim as the worst trading day since 1950, the so-called Black Monday crash of October 1987, which erased more than 20% from the S&P. But even that drop turned out to be a blip, albeit an incredibly large one, on an otherwise tremendous, nearly two-decade bull market run for stocks.

Will we look back on the last third of 2008 as another bump on the long road to prosperity? I won't make a market prediction for the next year, or even two years, but valuations have improved considerably in recent months, and there are some successful long-term investors who share that sentiment.

Don't be afraid of value
Marty Whitman, legendary value investor and manager of the Third Avenue Value Fund, had this to say about current opportunities: "Third Avenue wishes it had more liquidity, because then management would have been heavy buyers of high-quality equity securities, which are now as cheap as either of us ever remember them being."

Despite his less-than-ideal liquidity, he's also been snapping up shares of prominent companies like Toyota (NYSE:TM), whose valuations had been crushed, and the debt of the much-maligned General Motors (NYSE:GM). The S&P has fallen another 12% since he made that statement, so I'm confident that this asset hound has become even more optimistic. 

John Hussman, value investor and self-proclaimed "perma-bear," also thinks that current valuations are attractive. Hussman's Strategic Growth Fund has achieved cumulative growth of 101% since its inception in July 2000, versus a 43% loss for the S&P. Hussman was able to more than double the value of his fund largely by avoiding market exposure.

Now, for the first time in more than five years, Hussman believes that current valuations are blatantly attractive. He recently noted that "relative to the 30-year Treasury yields, the S&P 500 is priced to deliver the highest excess return since the early 1980s." Remember, the early 1980s marked the beginning of the greatest wealth creation in our nation's history.

Don't be afraid of volatility
Even though valuations are much more attractive now than they were this time last year, financial markets will remain volatile in the coming months. But if you have the discipline and willingness to search for companies that are unjustifiably cheap, I believe you will reap handsome rewards five to 10 years from now.

So, how do you keep your wits about you and invest in long-term winners? As a research analyst with our small-cap Motley Fool Hidden Gems service, I look for companies that possess:

  • Strong balance sheets
  • Wide moats
  • Room to grow

And I'll tell you why.

Strong balance sheets
Much of the hysteria in the market these days centers on the lack of access to capital. Companies that can internally fund their growth, or have enough cash to withstand a severe recession, should be at the top of your list. I recently added children's retailer Gymboree to our watch list. The company has absolutely no debt and plenty of cash on its balance sheet. It may not grow earnings at 20% for the next two or three years as it has in the past. But it has a strong enough financial position to ride out a slow economy.

Buffalo Wild Wings (NYSE:BWLD) has a similar story. Although reduced consumer spending will likely herald slower revenue growth than the most recent quarter's 29%, the company continues to fund its incredibly profitable new restaurants with the cash its business generates. The balance sheet is debt-free, and management is being disciplined in adding new stores as the team recognizes the economic headwinds it faces.

Wide moats
Companies with wide moats offer products or services that are extraordinarily difficult for a competitor or start-up to emulate. For example, Warren Buffett's Berkshire Hathaway (NYSE:BRK-B) was able to more than double a $1 billion investment in Constellation Energy (NYSE:CEG) after the company backed out of a proposed merger with Berkshire subsidiary MidAmerican Energy. Only Buffet could reel in such an eye-popping return on a deal gone awry.

Room to grow
Though emerging markets have been pummeled this year, some well-run companies will undoubtedly benefit as countries like Brazil, Russia, India, and China continue to advance. Foreign-based companies such as Chinese pharmaceutical company American Oriental Bioengineering (NYSE:AOB), should certainly play a role in any diversified portfolio. The company saw revenue jump 62% last quarter -- and that type of growth is extremely hard to come across in the developed world. But there are also a number of U.S.-based firms that have strong footprints in the emerging economies.

McDonald's (NYSE:MCD) is a terrific example of a large U.S. company that has managed to maintain healthy growth by tapping into emerging economies. McDonald's generates an increasing share of its revenue from countries outside of Europe and the U.S. In fact, more than half of the company's revenue growth in the most recent quarter came from Asia, Africa, and the Middle East.

Invest like it's 1987
Due to present fear-induced valuations, investors who demand these three must-haves from their investments stand an excellent chance of generating healthy returns over the long haul.

Unfortunately, discipline is perhaps the most difficult quality to develop on the road to becoming a great investor. As much as our brains draw on empirical data and the lessons of great investors, our emotions grab at headlines, euphoria, and -- more recently -- panic selling, when making decisions.

At Hidden Gems, we will never profess expertise at calling market bottoms or tops. In fact, we're skeptical of any who do. But we do know that proven investors with a demonstrated aptitude for consistently beating the market are shouting that stocks are cheap right now. 

We plan to listen to them, and to continue investing in companies that possess the aforementioned qualities. Such companies will lead the market higher when the inevitable turnaround comes -- just as they did when small caps leapt 23% after the roller coaster of 1987. You should try us out free for 30 days and have a look at the small caps that we believe the market is grossly undervaluing at the moment.

Click here for more information about a free trial.

This article was originally published Nov. 1, 2008. It has been updated.

Keith Beverly , a Motley Fool Hidden Gems analyst, owns shares of Third Avenue Value, Hussman Strategic Growth, and Gymboree. Buffalo Wild Wings and American Oriental Bioengineering are Hidden Gems picks. Third Avenue is a Champion Funds recommendation. Berkshire Hathaway is a Stock Advisor and an Inside Value choice. The Motley Fool owns shares of Buffalo Wild Wings, Berkshire Hathaway, and American Oriental Bioengineering. The Fool has a disclosure policy.