The Best Value Stocks

"Growth and value investing are joined at the hip."

You think that's crazy? Tell Warren Buffett. He's the one who said it, not me.

But, of course, I think he's right. I'm writing today because the largely semantic differences between value and growth often gets lost, even here at The Fool.

Head to head
That's because there is a temptation to equate growth investing with speculation, as fellow Fool Chuck Saletta did here.

But that's just wrong. Real growth investors don't bet on companies whose "sky-high" expectations make it nearly impossible to produce meaningful returns. More often, gurus like Will Danoff of Fidelity Contrafund or John Laporte of T. Rowe Price New Horizons invest in firms whose superior growth characteristics have yet to be recognized or rewarded by the stock market.

Value investors, on the other hand, look for stocks that trade for less than their intrinsic value, or stocks that the market has unfairly undervalued. Often, these firms are experiencing problems that investors believe to be temporary.

Both strategies, although seemingly different on the surface, operate on the premise that the market has mispriced a stock.

The obvious won't help you
Of course, you'll need more than math to discern what, exactly, is mispriced. Take the market's 10 best stocks. American Eagle Outfitters was trading for 28 times trailing earnings 10 years ago. A value investor simply looking for stocks with P/Es below the market average would have missed the 78-bagger to come.

Same with Chico's, an 87-bagger, which was trading for 21 times earnings a decade ago. 4 Kids Entertainment (NYSE: KDE  ) , a 54-bagger, didn't produce noticeable profits in 1997 and was trading for more than 50 times earnings the year before.

The very best value stocks
Stock market myth says that only value investors zig as others zag. Hogwash. Danoff, a star student of Peter Lynch, has been buying shares of Genentech (NYSE: DNA  ) , Merck (NYSE: MRK  ) , and Goldcorp (NYSE: GG  ) , none of which look "cheap" by the numbers.

Yet Danoff, by going beyond the numbers, has obliterated the return of the S&P 500 for more than a decade. So has Fool co-founder David Gardner. His best picks are the result of studying businesses whose capacity to rule high-growth industries leads to huge gains in cash flow. That's why Vertex Pharmaceuticals (Nasdaq: VRTX  ) has more than doubled for Rule Breakers subscribers. It was misunderstood. It was cheap relative to its growth potential. In short: It was a value stock.

Rules breaking, fortunes in the making
Don't make the mistake of confusing growth investing with speculation. You'll miss out on just about all of the market's best value stocks -- the misunderstood multibaggers in the making -- if you do.

Click here now if you'd like to join us at Rule Breakers in our quest to find the market next 10 best stocks. Your pass is free for 30 days and there's no obligation to subscribe. 

This article was originally published on Jan. 31, 2007. It has been updated.

Fool contributor Tim Beyers is a sucker for growth stocks and a regular contributor to Rule Breakers. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. American Eagle is a Stock Advisor pick. T. Rowe Price New Horizons is a Champion Funds recommendation. The Motley Fool's disclosure policy is a rebel on Wall Street.


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