You Are Right to Own This Stock

Here's a little tip most Wall Street-types would prefer you not know: The recipe for great returns in the stock market is startlingly simple.

You heard me
You might find that hard to believe, given that studies have shown most mutual fund managers underperform the market, but it is true. Empirical research from professors Eugene Fama and Kenneth French, along with that of Jeremy Siegel, supports the notion that excess returns are there for the taking for those who look for value-priced stocks.

But scholarly research is one thing. Application is another. If you're looking for a real-life example of the power of taking a long-run, value-focused approach to investing, look no further than the jaw-dropping success of one of the world's richest men, Berkshire Hathaway (NYSE: BRK-B  ) Chairman Warren Buffett.

How it works
This proven process for beating the market is actually pretty straightforward. Here's how it works:

  1. Buy great businesses.
  2. Buy them cheap.
  3. Be patient ... but bold.

Want more color? Let's dance.

1. Buy great businesses
Businesses with quality management and durable competitive advantages (a.k.a. economic moats) drive supreme long-run value for their investors. These competitive advantages allow companies to consistently earn returns in excess of their cost of capital, helping to fund growth, share repurchases, dividend hikes and, of course, boosting share prices. Put simply, moats make money.

Durable competitive advantages come in several forms. A few of the most valuable and well known are:

  • Network effects -- think Visa (NYSE: V  )
  • Cost advantages -- think Wal-Mart (NYSE: WMT  )
  • Intellectual property -- think Monsanto (NYSE: MON  )
  • Switching costs -- think Oracle (Nasdaq: ORCL  )

A quick and easy way to judge whether a company has a durable competitive advantage is to look at its historical returns on invested capital. If they're consistently strong (generally speaking, higher than 13%), you're probably looking at a strong business.

2. Buy them cheap
Finding great businesses takes you a long way toward market-beating returns. But there's just one problem: Great businesses rarely look cheap by traditional metrics. Let's look at some of the top-performing S&P 500 stocks from 1957 to 2003, according to the work of Jeremy Siegel:

Company

Annual Return

Average P/E

Altria

19.8%

13.1

Abbott Laboratories

16.5%

21.4

Bristol-Myers Squibb

16.4%

23.5

Tootsie Roll

16.1%

16.8

Merck

15.9%

25.3

S&P 500

10.9%

17.5

Source: Jeremy Siegel, The Future for Investors.

As the last column suggests, great businesses almost always look a bit pricey. What should investors do, then?

In the order of operations, finding a great company is first and foremost. Once you've identified said company, keep an eye on it until it comes down to at least a good price -- because it is possible to turn a good company into a bad investment.

Coca-Cola (NYSE: KO  ) , for example, rarely looks cheap. But when the shares were beaten down in 1988, Buffett backed up the truck for the wide-moat beverage giant, making a killing in the process. To quote Roger Lowenstein's Buffett biography:

By the latter part of 1988, Coca-Cola was trading at 13 times expected 1989 earnings, or about 15% above the average stock. That was more than a Ben Graham would have paid. But given its earning power, Buffett thought he was getting a Mercedes for the price of a Chevrolet.

Great company, good price. Buffett has built a fortune using that simple rule.

3. Be patient ... but bold
As I said earlier, great businesses don't often fall into the realm of cheap. When the rare fat pitch does cross your plate, though, don't be afraid to take a hard swing at it. Now, you might be thinking "That's great that Mr. Buffett was able to cash in on Coke 20 years ago, but pitches that fat just don't come along very often."

Au contraire, my friend. Bear markets such as this one, where investors are shouting doom and gloom from the rooftops, are a perfect time to find are the time to find great businesses at cheap prices.

Case in point? Recent Inside Value recommendation American Express (NYSE: AXP  ) . Shares of this wide-moat gem are near five-year lows, thanks to consumer weakness and the market's cold feet regarding anything even remotely tied to financials or consumers. Amex won't rocket up the charts overnight, but for patient investors who are willing to go against the grain and grab shares right now, the long-run return prospects look almost absurdly favorable.

If you currently have a position in American Express, you are right to own this stock -- it's a great business trading for a good price today. (And not coincidentally, Buffett is a longtime shareholder.)

So is value investing right for you?
Buffett-style value investing isn't right for everyone. Even if you're willing to take the time to identify outstanding companies with lasting competitive advantages, only a unique individual can confidently stroll into a market when peers are running for the exits.

Still, for those with the dedication and the right temperament, the intrinsic and financial rewards can be substantial.

With the Fool's Inside Value newsletter service, members receive two new investment ideas each month, along with continuing coverage of all past recommendations. You can find out the team's top five stocks for new money right now by signing up for a 30-day free trial.

Joe Magyer does not own shares of any companies mentioned in this article. Pity he doesn't have any more spare cash, or he probably would. The Motley Fool owns shares of Berkshire Hathaway and American Express, both of which are Inside Value recommendations. Berkshire Hathaway is also a Stock Advisor recommendation. Wal-Mart and Coca-Cola are Inside Value recommendations. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (54)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 05, 2008, at 11:42 PM, jaketen2001 wrote:

    I love all the guys at Fool, but calling Amex a wide moat gem? Couldn't disagree more. Their card no longer has any cachet. Merchants disdain it. They issued a new standard credit card that they aggressively issued and are now paying a price for. Company has continually reinvented itself, unsuccessfully, every few years.

  • Report this Comment On August 07, 2008, at 4:12 AM, Bendermann wrote:

    I agree with Jake... Amex is a sucky company. They have underperformed both Nasdaq and Dow Jones since 1980 and will continue to do so for years to come given the current environment. I would not even touch them with a pitch fork.

  • Report this Comment On August 07, 2008, at 8:52 AM, TMFJoeInvestor wrote:

    You folks are pretty harsh on a company with a massive, entrenched, and growing network effect and returns on equity north of 30%. As to the past performance, I pulled up a Google Finance chart (http://tinyurl.com/569873) and it shows AXP handily outperforming the S&P and running about even with the Nasdaq since 1980. However, that neglects the returns of the Ameriprise Financial spin-off, which adds considerably to the returns AXP shareholders have enjoyed. But, keep in mind we're only interested in past performance insofar as it affects the present opportunity.

  • Report this Comment On August 08, 2008, at 10:24 PM, dividendgrowth wrote:

    Amex also spun off Lehman Brothers in 1994, a very good investment until November last year.

    As for AXP underperforming the Naz and Dow since 1980, that's an utterly pathetic lie.

  • Report this Comment On August 16, 2008, at 12:47 PM, Fryatt wrote:

    Although I have 3 credit cards 2 visa and 1 Amex card I find many retailers want nothing to do with the Amex card ,as they claim the rate charged by Amex is to high.

  • Report this Comment On August 18, 2008, at 8:04 PM, britpick wrote:

    Seems the naysayers on this are focused on the credit card aspect of the business which, while probably the most visible and widely known, is not the only thing this company does. Don't forget the extensive travel related services and Business-to-Business group. I am marginally sceptical but prepared to listen to Tom and follow Mr Buffet. So on the whole I'd say go with it.

  • Report this Comment On December 01, 2008, at 6:42 AM, aber1911 wrote:

    I agree with jake. , ben. and dividendg.

    Amex is , on the credit card business , in my hopinion of course. , on the road to die .

    also here in Italy more and more retailers want nothing to do with it , too expensive.

    the finacial crisis now is just making thing worst and less people will use the credit cards

    I really really shocked that Inside Value is "promoting" amex

    (i'm a IV member , but due to the last too many errors and incredibles reccomm i'm thinking about if is worth it)

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