2008 was horrible! It was 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 already knew it was bad, of course, but did you know that half of the S&P's 10 worst trading days since 1950 happened in 2008? Half! Being down 37% 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 you're 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 to 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 am not calling a market bottom, 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
Bruce Berkowitz, legendary value investor and manager of the Fairholme Fund, had this to say about current opportunities: "Prices today are as attractive as I have seen in my career, and it will be worth the wait for the market to deliver the true value of these companies." Berkowitz holds large positions in health-care and defense names such as Humana
John Hussman, another value investor and self-proclaimed "perma-bear," also thinks that current valuations are attractive. Hussman's Strategic Growth Fund has achieved cumulative growth of 106% since its inception in July 2000, versus a 41% 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 "I do believe that the stock market remains undervalued." He went on to say, "passive, long-term investors are likely to achieve reasonably good market returns in the area of 10% annual total returns over the next seven to 10 years." Imagine that. He sees 10% returns for simply sticking your cash in an index fund. Based on his estimate, low to mid-double-digit returns over the next decade are quite attainable for disciplined investors with a proven market-beating investment strategy.
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 -- along with Hussman and Berkowitz -- that 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-focused 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.
Companies with wide moats offer products or services that are extraordinarily difficult for a competitor or startup to emulate. Johnson & Johnson
Room to grow
Though emerging markets have been pummeled this year, some well-run companies will undoubtedly benefit as the likes of Brazil, Russia, India, and China continue to advance. Foreign-based companies such as China's Ctrip.com
McDonald's is a terrific example of a large U.S. company that has managed to maintain healthy growth by tapping into emerging economies. The fast-food chain generates an increasing share of its revenue from countries outside Europe and the United States. 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
Because of current 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 timing the market. In fact, we're skeptical of any who make such a claim. 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 agree wholeheartedly. We are so firm in our belief that this month we will begin investing a quarter of a million dollars behind our best ideas, not to mention reviewing each of our existing recommendations. For the first time ever, our members will have the benefit of seeing exactly what we think a portfolio of Hidden Gems recommendations should look like.
We will 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 by 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.
Fool contributor Keith Beverly owns shares of Hussman Strategic Growth Fund and the Fairholme Fund, a Champion Funds selection. Johnson & Johnson is an Income Investor recommendation. Ctrip.com is a Hidden Gems selection. The Fool has a disclosure policy.
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