I want to tell you about a friend of mine; let's call him Fred. Fred's a fairly seasoned investor, except that he takes what he calls "flyers" -- small bets on story stocks or stocks with what they call momentum. Some days he's a joy to be around -- other days it pays to steer clear.

Those bad days, as you might have guessed, are the days when one -- or, heaven forbid, two -- of his flyers suffers a 20% stumble. One day it's a software developer. The next it's a drug maker or contract research outfit. Then it's a company that makes stun guns, of all things.

What do all these flyers have in common?

  • They're expensive.
  • They're hyped on Wall Street.
  • They're on CNBC and all over the chat boards.

They're what we in the business call overextended. And they're sure as heck not the kind of stocks we talk about -- at least in a good way -- at Inside Value.

According to well-known research firm Ibbotson Associates, value investing flat outperforms both growth investing and the S&P 500 by a wide margin. In the period from December 1968 to December 2002, value stocks returned 11.0% per year, growth stocks 8.8%, and the S&P 500 returned 6.5%. Previous studies over longer periods of time show the same outperformance by value stocks but with the S&P 500 also beating growth.

While impressive, the percentage difference doesn't tell the whole story. Consider the returns of $1,000 invested at the end of 1968.

  • $1,000 invested in the S&P 500 grew to $8,471.
  • $1,000 invested in growth stocks grew to $17,520.
  • $1,000 invested in value stocks grew to $34,630.

It seems clear to me. If you want better returns, be a value investor!

Borrowing from the masters
At Inside Value, we have had quite a discussion as to what constitutes value and who qualifies as a value investor. Some take the Benjamin Graham route, looking for deeply undervalued stocks that are trading at or below book value and preferably at a discount, or margin of safety, of at least 50% to their estimation of the intrinsic value. These are the "deep value" guys, and when the stock approaches intrinsic value, they sell and repeat the process. Current Inside Value pick MCI Inc. (NASDAQ:MCIP) fell into this category when I picked it.

Others are more like Warren Buffett and Charlie Munger at Berkshire Hathaway (NYSE:BRK.A), still looking for a big margin of safety with the caveat that they are prepared to pay up for companies that truly display long-term competitive advantages. These are companies such as Coca-Cola (NYSE:KO) and American Express (NYSE:AXP).

Then there are others that follow the path less traveled and are true contrarian investors, such as David Dreman, author of Contrarian Investment Strategies and highly successful manager of the Scudder-Dreman funds. Dreman looks for value in distressed companies that few others want, such as Tyco (NYSE:TYC) in 2002 and American International Group (NYSE:AIG) recently, when the stock dropped 20% in the wake of Eliot Spitzer's allegations that Marsh & McLennan (NYSE:MMC) was rigging insurance bids.

To me, there is a clear and consistent theme in all these cases. In each, the value investor assesses the intrinsic value and applies some margin of safety to establish the buy price. The value investor then waits patiently for the stock price to drop below the buy price and will not chase a rising stock price above that level. The next component again involves patience -- the patience for the market to recognize the undervaluation.

The hunt for value
I don't have a hard-and-fast rule that I must have a 40% discount to my conservative estimate of intrinsic value before I will invest in a company. In my mind, not all companies or stocks are created equal. Of course, I want to buy Coca-Cola at a 40% discount, but I don't ever expect to see it trading that low in my lifetime. However, its earnings have been so predictable over a very long period, I might be prepared to buy it at a small discount to my estimation of intrinsic value.

In hunting for value, I generally break the field down into six different areas. We'll look at those in my next online commentary and take a closer look at a few examples from each segment.

And this is what we discuss in every issue of Inside Value. You've read this far, so apparently you share some of our thoughts on investing. If you're trying to decide whether to take the next step, let me help make your decision a little easier. Try the first 30 days on me. No charge. Now that's value. If you are not 100% convinced that Inside Value will make you money, you won't pay a dime. You owe it to yourself as an investor to learn about value investing.

By signing up, you also are invited to our dedicated online discussion boards, where your fellow members and I partake in spirited discussions day and night. We can talk about the market, your favorite value picks, and those on my current Watch List.

So, I wish you good value investing until we chat again. Oh, and Fred, try to stay away from those flyers.

Philip Durell is the analyst for the Motley Fool Inside Value newsletter. He owns no shares in the companies mentioned.