How to Crush the Market

It's been a year since we launched the Motley Fool Inside Value newsletter and things are going great! Over that time period, Inside Value has crushed the market, performing twice as well as the S&P 500 with average returns of 10.11% vs. 4.44%.

These numbers are even better than they first appear, since this average includes the stocks that were recommended just last month, and the typical stock pick has only been in the portfolio for six months. The longer that a stock is in the portfolio, the longer it has to perform, and it really shows in the results. The first six stock picks, the ones that have been in the portfolio for at least nine months, are up an average of 35%.

Of course, our goal at The Motley Fool is to educate as well as enrich -- we wouldn't want to have a bunch of ignorant millionaires running around, would we? So I'm going to share with you some of the techniques we use for identifying stocks that are likely to have superior performance.

Find a great company
Our approach to selecting recommendations is more similar to Warren Buffett's strategy than Benjamin Graham's. Graham focused primarily on cigar butts -- dirt-cheap companies trading for less than their assets or a really low multiple of earnings. Buffett tends to focus on relentless growers -- dominant companies that are in such a powerful position that it's clear they'll still be generating piles of cash for years to come.

Thus, Inside Value's analysis of a company begins with an understanding of its business and competitive position. Like the companies that Buffett buys, all but three of Inside Value's recommendations have dominant industry positions that make it extremely difficult for other companies to compete with them. While companies like Sirius (Nasdaq: SIRI  ) that have huge growth potential in evolving markets are exciting, they come with significant execution risk. Most of the companies Inside Value looks for, on the other hand, are relentless growers -- companies that are almost certain to deliver solid growth for years.

Consider Anheuser-Busch (NYSE: BUD  ) , which was an Inside Value pick a few months before the company revealed that Buffett was also buying shares. Anheuser faces competition from companies such as SABMiller and Molson Coors (NYSE: TAP  ) , but still has almost 50% of the U.S. beer market. Anheuser's scale provides huge advantages against competitors. Its distribution network is unparalleled in the North American beer market, and it has the financial clout to expand outside the U.S. into markets like China. The company is likely to be able to continue to dominate its markets and grow for decades.

But just because these companies are dominant in their niche doesn't mean that they're all colossal conglomerates. After all, we're looking for companies that are both strong and growing. While the largest recommendation has a market capitalization of almost $200 billion, four companies have been recommended with market caps of about $2 billion, and the median market cap is about $17 billion. The picks also span a variety of sectors, from technology to consumer non-cyclical.

Understand the risks
After we've identified a completely dominant company, we analyze the risks to that company. After all, even dominant companies have risk factors that can potentially slow their growth. At one time, AT&T (NYSE: T  ) was dominant; it seemed everyone owned its stock. Now, the stock seems about as popular as that vaguely identifiable gooey mess your dog regurgitated. Microsoft (Nasdaq: MSFT  ) is arguably the most dominant technology company of all time, yet right now Google (Nasdaq: GOOG  ) and Apple (Nasdaq: AAPL  ) seem to be running circles around it, both in terms of innovation and financial performance.

So the next step in our process is to carefully examine any risks the company is facing. We'll consider issues such as the impact of currency and interest-rate fluctuations, debt loads, regulation, the loss of critical customers, market changes, potential pricing pressures, litigation, and key personnel changes. A discussion of the most important factors is a major component of the write-up accompanying every Inside Value recommendation.

Price the stock
After we have a great understanding of a business, we conservatively calculate its intrinsic value, using methods such as a discounted-cash-flow analysis. If the company seems like a huge bargain, then it becomes a recommendation. If it looks cheap, but not quite cheap enough, it will often become a watch-list stock, for potential purchase should its price fall.

We take valuation seriously. We only recommend stocks that we believe are significantly undervalued, and we discuss in detail the fair value of each recommendation. On average, our picks were trading at prices equal to 72% of their fair value when they were recommended. In other words, if these stocks simply returned to fair value over the course of a year, investors would earn about 40%. Of course, since we're generally buying relentless growers, then after a year, each company's fair value is likely to increase, too.

Last year, the recommendation at the biggest discount to its fair value was MCI, which was trading at about 55% of its intrinsic value. After a bidding war between Verizon and Qwest, it's now trading 73% higher than the price at which it was recommended, even before its healthy dividend.

The current recommendations are now priced at about an 80% discount to fair value. It's unfortunate that they're less undervalued that they were when they were initially recommended. But considering that the discount has narrowed because the stocks have gone up in price, there are worse problems to have.

Our top stocks
Of course, since many of our recommendations have appreciated substantially, what was a great pick a few months ago may now be too expensive. So this month's newsletter re-examines all the past picks and ranks their current attractiveness. The top picks are trading at about 75% of intrinsic value, while one company is trading at a huge discount, about 58% of its fair value.

Inside Value provides updates on picks as they experience significant events, but this issue's extensive review only happens once a year. So now is a particularly good time to take advantage of our free one-month trial to Inside Value. Not only will you be able to read about our top recommendations, but you'll be able to access the full breadth of Inside Value content, including all historical issues of Inside Value, a discounted-cash-flow calculator for valuing any stock, book reviews, dedicated discussion boards, and two Inside Value special reports. Our combination of stock picks and education will help you get closer to crushing the market.

Richard Gibbons, a member of theInside Valueteam, does not own shares of any stock discussed in this article. The Motley Fool isinvestors writing for investors.


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