On Faith, Gambling, and Picking Great Stocks

Investors come from all walks of life. As a result, we all have different criteria for selecting stocks. Sometimes these even mirror our own character. The more conservative among us, for instance, probably stay away from penny stocks.

But I've learned that every time an investor puts hard-earned money behind a stock, he or she has identified at least one trait that will drive that stock's growth. Maybe it's a great product, defensible intellectual property, a strong brand, or all of the above. Whatever it is, where investors tend to put their faith has a tremendous effect on their investing success.

Blind faith
Early in my investing life, I put a lot of faith in momentum. The theory was that stocks that the booming market was sending up will keep going up. So what did I do? I put an inordinate percentage of my portfolio behind a little-known company that was growing dramatically through acquisitions. I didn't have a clue what its business model was, what markets it hoped to capture, or even if the management had much tenure in the corporate world. The only thing I knew is that the stock had been doing really well.

And the strategy worked ... for a while. But I learned my lesson when the stock plummeted and the officers of the company came under investigation by the SEC. This was a major wake-up call for me. Momentum wasn't the answer.

Moreover, I've found that there are a number of other popular investment strategies that don't seem like the answer for investors. These include:

1. Investing in hopes of a buyout.
Too many investors actually buy a weaker company in hopes that the market leader will buy them out at a premium. For instance, why buy shares of flailing microchip producer Zilog when you could back a leader such as Intel (Nasdaq: INTC  ) or Advanced Micro Devices (NYSE: AMD  ) ? While betting on a buyout is an uncertain proposition, many master investors seem to think that Intel is pretty cheap today.

2. Investing based upon a single popular product.
Following the latest "hit" product or service is risky. It's little more than a crapshoot to buy Apple Computer (Nasdaq: AAPL  ) because of the iPod or Motorola (NYSE: MOT  ) because of the RAZR. These companies could both do well going forward, but it will be because of more than one simple product. It's better to look for other qualities behind these hit products to see if the current success can be replicated.

3. Investing in hopes of a legal win.
Lawsuit judgments can mean hundreds of millions of dollars these days. No wonder, then, that investors put money in companies embroiled in legal tiffs hoping for a big payday. Rambus (Nasdaq: RMBS  ) , for instance, has had mixed success in the courtroom, and investors have been on a wild ride because of it. Betting on the outcome of lawsuits can be lucrative, but it's a different game than investing in undervalued streams of cash flows.

4. Investing in hopes of securing a major contract.
In the wireless market, I routinely hear of investors betting on equipment providers such as Lucent Technologies (NYSE: LU  ) and Nortel Networks (NYSE: NT  ) in hopes that they will win a pending, major network contract with a service provider. While these contracts can mean billions of dollars, they are only a drop in the bucket of the larger picture.

The common threat among all of these strategies is that they're more speculation than investing. What's worse, they also often have binary outcomes -- the stock will either go way up or way, way down. In other words, while money can be made these ways, they're risky and can be extremely unpredictable.

Finding a new religion
Rather than a litany of expectations that can be cited as motivation for investment, I've decided to try a different religion, one that puts faith in the fundamental driver for everything -- a company's management team. After all, the capability of a company's leadership team is what is actually the behind positive prospects and even negative expectations that the market prices into stocks everyday. So rather than gauging what are essentially effects of company operations, I aim to better assess the fundamental cause of success or failure: The executive team and board of directors.

Great, longstanding management teams correlate with outstanding returns, and that's exactly why Motley Fool Hidden Gems analysts Tom Gardner and Bill Mann search them out in the small-cap universe. They listen to conference calls. They chat with and interview CEOs and members of senior management. They don't put money behind false gods or short-term events: If they don't believe management can drive success during both good and bad times, they don't invest -- and they don't recommend you do, either.

To get a first-hand assessment of the leadership behind hundreds of small companies that Tom and Bill recommend you buy, or avoid, click here to try Hidden Gems free for 30 days. It's a risk-free way to see if a new religion is what you need in order to save your portfolio.

Intel is an Inside Value recommendation.

Fool contributor Dave Mock loses his religion on a regular basis, but fortunately finds it again pretty quickly. He owns shares of Lucent, Motorola, and Intel. A longtime Fool, Dave is also author of The Qualcomm Equation . The Fool has a disclosure policy .