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. Particularly given today's environment.

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, 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, and 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 LoopNet (Nasdaq: LOOP)
• Cost advantages -- think PotashCorp (NYSE: POT)
• Intellectual property -- think Genentech (NYSE: DNA) or International Speedway (Nasdaq: ISCA)
• Switching costs -- think Microsoft (Nasdaq: MSFT) or Verizon (NYSE: VZ)

A quick 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 (NYSE: BMY)	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, 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 great businesses at cheap prices.

Case in point? Recent Inside Value recommendation American Express. Shares of this wide-moat gem have been hovering around 10-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 great price. (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.

This article was first published on Aug. 5, 2008. It has been updated.

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 American Express. Coca-Cola, American Express, and Microsoft are Inside Value recommendations. LoopNet is both a Motley Fool Hidden Gems and a Rule Breakers recommendation. The Motley Fool has a disclosure policy.