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This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.
Value investing appeals to many people -- and they're in good company. It's the preferred method attributed to investing greats like Benjamin Graham and Warren Buffett.
Value investors search for stocks that the market has priced below each company's true business value and future growth potential. These can include stocks with low price-to-earnings ratios (compared to their own growth estimates, or to peers') as well as beaten-down or misunderstood stocks.
Finding stocks that are trading at red-hot sale prices is an obvious way to make money in the market. However, value investing is easier said than done.
First of all, value investing requires patience. This method doesn't involve the frenetic activity of day trading or the relatively quick rewards that can be gained in the wild boom-or-bust world of growth investing.
Recent IPOs like LinkedIn (NYSE: LNKD ) and Dunkin' Brands (Nasdaq: DNKN ) that surged right out of the gate, with seemingly little thought of fundamentals or valuation, likely raised many self-respecting value investors' eyebrows.
If the idea of value investing appeals to you, you should probably be comfortable examining fundamental strengths of companies, study hard, prepare a watch list of stocks, and wait for the right price. Once you pull that trigger, you should be prepared to hold for a long period of time.
Seeing value beyond pessimism
Every once in a while, value investors stumble on some awesome opportunities to grab great stocks on the cheap.
In late 2008, slews of investors had given up on Starbucks (Nasdaq: SBUX ) , once one of Wall Street's growth darlings. Granted, their pessimism wasn't exactly unfounded. The U.S. economy looked precarious, and Starbucks -- long a symbol of pricey coffee and affluent times -- had hit the skids and was definitely struggling.
However, Starbucks was trading at a historically unheard-of price-to-earnings multiple of just 10 times earnings. Could Starbucks be that weak? On Dec. 18, 2008, I decided that despite its challenges, the java giant had become truly dirt cheap, and I nominated Starbucks as The Best Stock for 2009. In 2009, Starbucks increased 144%. Since late 2008, Starbucks stock has quadrupled in price.
If you've been watching stocks even longer, you might remember that about 10 years ago, just about everyone had left McDonald's (NYSE: MCD ) for dead. The late Jim Cantalupo took the CEO reins and sparked an incredible turnaround. Since Jan. 1, 2003, McDonald's has jumped almost sevenfold and continues to consistently surpass analyst expectations.
Key components of value investing include the ability to see through overdramatic pessimism, buy high-quality stocks at good prices, and hold. As you can see, you can build a great portfolio this way.
Beware the value traps
If you're eager to start value investing, though, remember the pitfalls. A beaten-down stock with a well-known name can look like a no-brainer ticket to riches, but it ain't necessarily so, folks. Enter the frightening world of the "value trap," which puts portfolios in peril.
Recently bankrupt Borders is a good historical example. When it first hit hard times, it looked like a real value. It was a well-known consumer-facing retailer, its share price was getting beaten down, and it boasted an influential and respected majority shareholder: Pershing Square's Bill Ackman. Could anyone even imagine a world without Borders?
Still, we know now that Borders was actually entering a perfect(ly horrible) storm: a nasty economy, extremely formidable competition, and majorly disruptive influences like e-books and digital music. It also had a hand in destroying itself, since its lack of a differentiating strategy was hardly helped by the huge debt load that continuously sapped its chances of profitable operations.
Basically, Borders was no value stock. In the end, Borders' shares basically went to zero. Any investor who bought in years ago and held would have plenty to regret right now.
Go for the gold
To really be a successful value investor, remember one of Warren Buffett's pieces of advice (he's the Oracle of Omaha, after all): Find outstanding companies at reasonable prices. Avoid the temptation to buy up lackluster companies at supposedly bargain-basement prices; that's where many dogmatic value investors can go wrong. Some stocks are cheap for a very real reason, and in the long run, investors find they were never "deep values" at all.
Don't be afraid to question the prevailing conventional wisdom, either. For example, Wal-Mart (NYSE: WMT ) may look like a major bargain stock right now, at just 11 times earnings. But I consider Costco (Nasdaq: COST ) a better value, despite its higher price-to-earnings ratio of 24.
Costco has an amazing management, nimble business model, conservative balance sheet, and a voraciously loyal customer base. Should Costco get hit with a load of pessimism tomorrow, and see its stock plunge in response, it would only become an even better value. Value investors wait for such opportunities to load up or add to positions.
Happy investing, Fools. Here's to grabbing shares of great companies at value prices.
Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.