How to Crush the Market

If you're looking for a get-rich-quick strategy, value investing is not for you. Because value investing -- as practiced by Benjamin Graham, Warren Buffett, Bill Miller, et al -- is all about getting rich slowly. The formula is simple: Find superior companies, buy them when they're on sale, and patiently wait for the market to recognize their true value. It's the only time-tested strategy for long-term market success, but it won't make you rich overnight.

It's been more than a year since we launched the Motley Fool Inside Value newsletter service, and we've tried to display that patience thus far. Since the newsletter's inception in September 2004, Inside Value recommendations have gained 12%. For context, the market (as measured by the S&P 500) has returned just 9%.

We believe these numbers will only improve with time; the average stock pick has only been in the portfolio for eight months. Value investing requires more patience than that. If you can be patient, you'll greatly increase your chances of outperforming the market.

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 enjoy superior performance.

Find a great company
Our approach to selecting recommendations is closer to Buffett's strategy than Graham's. Graham focused primarily on cigar butts -- dirt-cheap companies trading for less than the value of their assets, or for a really low multiple of earnings. Buffett tends to focus on relentless growers -- dominant companies whose powerful position ensures that they'll still be generating piles of cash for years to come.

At Inside Value, our 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, making it extremely difficult for other companies to compete against them. While companies like Salesforce.com (NYSE: CRM  ) 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 title insurer First American (NYSE: FAF  ) , which was an Inside Value pick a year and a half ago at $29. While the company faces strong competition from Fidelity National Financial (NYSE: FNF  ) , First American is undeniably holding its own -- it's the No. 1 or No. 2 player in every market in which it competes. Its profit margins are solid, its top-line growth rate is the best in the sector, and it throws off piles of cash. The company will likely continue to dominate its markets and grow for decades.

But just because these companies are dominant in their niche doesn't mean they're colossal conglomerates. After all, we're looking for businesses that are both strong and growing. While our largest recommendation has a market capitalization of more than $200 billion, we have recommended 12 companies with market caps of $3 billion or less, and the median market cap is about $15 billion. The picks also span a variety of sectors.

Understand the risks
Once 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, Siebel Systems (Nasdaq: SEBL  ) and SunMicrosystems (Nasdaq: SUNW  ) were two of the most exciting and innovative technology companies around, both dominating their rapidly growing niches; it seemed everyone owned them. Now, they're not so hot. For decades, Albertson's (NYSE: ABS  ) was a dominant company that deserved consideration for any stock portfolio. But fierce competition from Wal-Mart (NYSE: WMT  ) , high labor costs, poor operating performance, and excessive debt have so eroded Albertson's position that the future of the company is uncertain.

So the next step in our process is to carefully examine any risks the company faces. 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 Valuerecommendation.

Price the stock
After we have a great understanding of the business, we conservatively calculate its intrinsic value, using methods such as a discounted cash flow (DCF) analysis. If the company seems like a huge bargain, it becomes a recommendation. If it looks cheap, but not quite cheap enough, it will often be added to the Watch List as a potential value play 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 one. 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 return to fair value over the course of a year, investors would earn about 40%. Of course, since we're generally buying relentless growers, after a year, each company's fair value is likely to have increased as well.

In the newsletter's first year, the recommendation trading at the biggest discount was MCI, which was at about 55% of its intrinsic value. After a bidding war between Verizon and Qwest, it rose about 75% higher than the price at which it was recommended, even before its healthy dividend.

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 every so often, we re-examine all past picks and rank their current attractiveness. Value investing may be a buy-to-hold endeavour, but you still have to keep tabs on your investments.

If you're interested in investing the get-rich-slowly way, Inside Value is offering a free 30-day trial. A trial gives you access to all our recommendations, as well as the full breadth of Inside Value content: all back issues, a DCF calculator for valuing any stock, book reviews, dedicated discussion boards, and three Inside Value special reports. As a bonus, if you subscribe for a year, you'll receive Stocks 2006: The Investor's Guide to the Year Ahead for free. Our combination of stock picks and education will help you get closer to crushing the market.

This article was originally published on Aug. 17, 2005. It has been updated.

Richard Gibbons, a member of theInside Valueteam, wants to get rich slowly, but won't quibble if it happens quickly instead. He does not own shares of any stock discussed in this article. The Motley Fool isinvestors writing for investors.


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