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, and Bill Miller, to name a few -- 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 and a half since we launched the Motley Fool Inside Value newsletter service, and we've tried to display some patience thus far. Since the newsletter's inception in September 2004, Inside Value recommendations have gained 9%. For context, the market (as measured by the S&P 500) has returned just 5%.

We believe these numbers will only improve with time; the average stock pick has been in the portfolio for only 12 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 to Graham's. Graham focused primarily on cigar butts -- dirt cheap companies trading for less than the value of their assets or for a low multiple of earnings. Buffett tends to focus on relentless growers -- dominant companies whose powerful positions ensure that they'll generate piles of cash for years to come.

At Inside Value, our analysis of a company begins with an understanding of its core business and competitive position. Like the companies Buffett buys, all but three of our recommendations have dominant industry positions, making it extremely difficult for other companies to compete. Biotech companies such as Myogen (Nasdaq: MYOG  ) have huge growth potential and can change the world. Though exciting, these companies come with significant risk. If they fail to find safe and effective drugs, investors have a high chance of losing their entire investment. Most of the companies Inside Value looks for, on the other hand, are relentless growers -- companies that are almost certain to deliver years of solid growth.

Consider Intuit (Nasdaq: INTU  ) , which was an Inside Value pick back when it was trading in the $30s. Intuit faces some strong competition. It's been going head-to-head with Microsoft (Nasdaq: MSFT  ) for years in the personal finance software market and with H&R Block (NYSE: HRB  ) in the tax preparation software market. Yet despite this competition, Intuit has managed not just to maintain its position but to actually improve it. The company likely will continue to dominate its markets and grow for decades. The market has started to realize this and has pushed shares up more than 60% since it was recommended.

But just because 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 13 companies in a variety of sectors with market caps of $3 billion or less. The median market cap is about $17 billion.

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. The fear of technological change has been hurting eBay (Nasdaq: EBAY  ) recently -- even before the company has felt the effects. Investors are terrified that Google's (Nasdaq: GOOG  ) new online payment system could compete with eBay's PayPal. Add to that concerns about Google's eventual impact on online markets like eBay's auctions, and it starts to make sense that the stock's been struggling for a year and a half.

Such displacement doesn't just happen to technology companies. For decades, newspaper companies like McClatchy (NYSE: MNI  ) have had near monopolies over print advertising in their local markets. But the Internet has changed the game, leaving newspaper companies scrambling to adjust to declining readership and falling ad rates.

So the next step in our process is to carefully examine any risks. We'll consider issues such as currency and interest rate fluctuations, debt loads, regulation, loss of critical customers, market changes, potential pricing pressures, litigation, and key personnel changes.

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 often will be added to the Watch List as a potential value play should its price drop.

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, each company's fair value is likely to have increased after a year as well.

Our top stocks
Because many of our recommendations have appreciated substantially, what was a great pick a few months ago may now be too expensive. So we periodically re-examine all past picks and rank their current attractiveness both in terms of pure upside and on a risk-adjusted basis. Value investing may be a buy-to-hold endeavor, but you still have to keep tabs on your investments.

If you're patient and are interested in investing the get-rich-slowly way, Inside Value is offering a free 30-day trial. A trial gives you access to all of our recommendations as well as to the full breadth of Inside Value content: back issues, a DCF calculator (for valuing any stock), book reviews, dedicated discussion boards, and five Inside Value special reports. Our combination of stock picks and education will help you get closer to crushing the market. To find out more, click here.

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

Richard Gibbons, a member of the Inside Value team, wants to get rich slowly, but he won't quibble if it happens quickly instead. He owns shares of H&R Block but does not own shares of any other stock discussed in this article. Microsoft and Intuit are Inside Value recommendations. eBay is a Stock Advisor pick. The Motley Fool isinvestors writing for investors.


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