Stocks on the Rise

It's easy -- and useful -- to follow the crowd at times. Folks follow trends in fashion (what's in for spring?) and electronic gadgets (another iPod, anyone?), for instance. But following the crowd as an investing strategy? That's an entirely different story, and for those of us who had huge losses in the post-2000 Nasdaq crash, it's one we'd like never to repeat again.

Sure, if you get in early enough, you can make some big short-term gains by following what's commonly called momentum investing. There's even a pretty savvy measure you can use to push these dollars up the hill -- it's called "relative strength." But for most of us, that's a recipe for buy-high-sell-low disaster.

Take advantage of the herd
A little thing called value investing -- preached by a few luminaries you may have heard of (Graham, Buffett) -- can help you buck such a herd mentality. Value investing involves using financial metrics to determine what companies are great and have the potential for long-lasting returns. But the important thing is to wait for the rainy day when the market panics -- and buy the stock at a discount to its intrinsic value.

Consider a few examples:

Case in point No. 1: The aforementioned tech bubble
During that bubble, there was a "next big thing" at every turn. The list included, but was certainly not limited to, Harmonic (NASDAQ:HLIT), Aspen Technology (NASDAQ:AZPN), Arris Group (NASDAQ:ARRS), Parametric Technology (NASDAQ:PMTC), and Buyjunknow.com. As investors who played the momentum game at that time now know, following the train (wreck) can lose you some hefty stacks of cash.

But if you'd recognized the worth of these companies and their business models while the market was reacting to the crash, you could have found some real value -- the average gain for these companies from the end of 2002 to today is nearly 300% (or 31% annualized). That's a lot of incentive to be contrarian when the masses are screaming "Buy!" or "Sell!"

Case in point No. 2: Overanalyzed and overhyped IPOs
For a more recent example, take a look at CBOT Holdings. It IPO'd late in 2005 at $96 a share, shot up to $131 a share purely on momentum, and then plummeted to $89 a share. If you'd followed the momentum crowd, you would have lost a significant amount of money when you sold on the weakness. But if you chose CBOT as a value play, you could have bought into it at the low price and more than doubled your money in a little more than a year.

Case in point No. 3: Great business, short-term worry
According to Jeremy Siegel's The Future for Investors, the best-performing stock in the entire S&P 500 since its inception has been Altria, with an annualized return of 19.8%. But even this mammoth performer had its ups and downs when the momentum crowd was changing its mind -- the company's stock price went from a split-adjusted high of nearly $60 a share in 1998 to less than $20 just two years later. This is a prime example of a value play -- if you had the knowledge and courage to invest in a great company when the rest of the market was overreacting to a negative outlook, you would be very happy with your returns today.

Up and down, and back around
Value investing can help you beat the momentum crowd. It's where you find a great company and simply wait for it to go on sale.

If you think this can't happen, even the greatest of great companies -- such as Legg Mason (NYSE:LM) -- fall out of favor at times. When Legg Mason fund manager Bill Miller seemed in danger of trailing the S&P 500 index for the first time in 16 years and money was flowing out Legg Mason funds, the company's shares dropped by more than 30%. Yet this is a strong operator with a plan in place to turn the tide -- and the stock has responded since the lows of late last year.

Motley Fool Inside Value  analyst Philip Durell waits for exactly these opportunities. He creates a wish list of stocks and waits to pay the right price. He did this with Legg Mason, which he recommended to Inside Value subscribers in December 2006. Such a contrary strategy has put his service almost 7 percentage points ahead of the market, and many of his recommendations are still trading at what he considers to be bargain prices. To find out what they are, click here to be Philip's guest at the service free for 30 days.

Everyone wants a piece of a stock on the rise. But by being a value investor, you can find stocks before they rise.

This article was originally published on April 17, 2006. It has been updated.

Shruti Basavaraj does not own shares of any company mentioned above. The Fool's disclosure policy is sealed for freshness.