Since the end of the Great Depression, generations of value investors have beaten the stock market's broad indexes. That's a pretty impressive track record, especially since some of the greatest academic minds believe that the market is too efficient to let any real advantage last. Yet value's advantage has lasted -- surviving even the tech boom and resulting dot-com implosion, and it's still succeeding today.
This raises a few key questions: What gives value investors their edge? How can they routinely do what baffles some of the most brilliant minds in academia? And, most importantly for those of us looking to emulate the greats who came before us, how do we use that information to make money for ourselves?
Three critical tools
Fortunately for us, value investing isn't exactly rocket science. To be successful, you simply need three key tools:
- A list of companies you'd love to own.
- A sense of the fair value of each of those companies.
- The patience to let the market work for you.
If you put all those pieces together, you can build yourself a powerful, market-trouncing portfolio.
The watch list
To beat the market, you must know what businesses you'd love to buy -- if the price were right. This means doing your due diligence and investigating companies before purchasing shares in them. If you know your business well enough, you will be able to recognize and take advantage of discounted prices when the market makes them available.
Great companies to have on your watch list are ones that are exceptionally strong businesses in solid financial conditions that, unfortunately, trade like the high-class enterprises they are. Starbucks (Nasdaq: SBUX ) , for instance, holds a place high on my watch list. I'd love to own shares in one of the best success stories of this generation, but I can't quite justify paying the market's current price of more than 40 times earnings. The market is expecting its tremendous past growth to continue unabated. Judging from chairman Howard Schultz's recent comments, however, even insiders realize that its future growth may be at risk.
The right price
If its stock does swoon low enough, I intend to buy, much like I recently bought Select Comfort (Nasdaq: SCSS ) when its shares fell from premium status to the bargain basement. As experience has shown time and time again, the difference between owing a great company and making a great investment is paying the right price for the shares. And if Starbucks' stock never falls? Well, that's why my watch list -- and the watch list we keep at Motley Fool Inside Value -- includes more companies to consider, like American Express (NYSE: AXP ) and others.
The truth is that we're never sure when a bargain will come around, but we are pretty confident that one will. The market routinely throws sales in one stock, even when it's busy overvaluing another. Think about the tremendous value in energy giants like ExxonMobil (NYSE: XOM ) and Chevron (NYSE: CVX ) when the technology bubble was at its peak. As the tech boom reached its pinnacle, people actually started to believe that the real goods economy would essentially give way to the virtual one, lessening the need for oil. As silly as it seems now, it did provide you with an opportunity to buy great companies very cheaply, just a few short years ago.
Yet to profit from that market behavior, you need to know what makes a stock price a legitimate bargain. For that, you need to understand what a fair price is for a stock. At its roots, a stock is nothing more than a claim on a company's future earnings. To figure out what it's really worth, all you need to do is add up your best guess of those future earnings, dialed back to their true value for today. It's called a discounted cash flow calculation, and if you can accurately project those future earnings, it'll tell you what a company is really worth to you today.
Fortunately, the math behind that calculation is straightforward. At Inside Value, in fact, we've got a calculator that does the figuring for our members. (If you're not yet on board, you can take a 30-day free trial to see how it works.) The tough part is that for the calculator to spit out that true value, you've got to be able to tell it what those future earnings will be.
Unfortunately, nobody knows that future with any certainty, and the best we can do is estimate. Then, to turn our estimate into a buy price, we simply knock off a percentage from that price and buy if the shares fall below that level. It's called using a margin of safety, and it's so important that Benjamin Graham called it "the central concept of investment."
Even if we know what we want to buy and the price we want to pay, we can't control the market. We don't know when it will give us the sale price we're hoping to see on one of the stocks on our watch list. All we know is that, eventually, it will. Even multibillion-dollar companies like Advanced Micro Devices (NYSE: AMD ) and Chico's (NYSE: CHS ) are subject to wild price swings as the market re-estimates their futures. Chico's, for instance, was recently down more than 55% from its 52-week high, and AMD was similarly down more than 63% from its own 52-week pinnacle.
As an investor, you'll never control the market, but you can control when you're willing to buy shares. The final device your toolkit needs if you want to become successful is the patience to wait for a value price before making a purchase. After all, you could have paid through the nose for AMD or Chico's, or you could have waited and bought them at a better price later. Of course, you had no way of knowing ahead of time that their shares would fall as far as they did.
By making full use of your complete toolkit, you may very well have had one of them on your watch list and known what price you'd be willing to pay. Then, simply by holding on to your cash until your buy price came around, you would have gotten that much more stock for your same investing dollar. If you'd like to learn more about value investing and see our favorite stocks for right now, click here for a free 30-day trial to Inside Value. Your portfolio will thank you for it.
At the time of publication, Fool contributor Chuck Saletta owned shares of Select Comfort, which is a Hidden Gems recommendation. Starbucks is a Stock Advisor recommendation. The Fool has a disclosure policy.