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 30% stumble. One day it's a purveyor of delicious donuts. The next it's a drugmaker that had its only significant drug prospect halted by the FDA. 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 Motley Fool 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 returned 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 fair value, they sell and repeat the process. When I started Inside Value, my very first pick, MCI Inc. (NASDAQ:MCIP), fell into this category.

Others are more like Warren Buffett and Charlie Munger at Berkshire Hathaway (NYSE:BRKa), 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 Gillette (NYSE:G) and Wells Fargo (NYSE:WFC).

Then there are others that follow the path less traveled and are true contrarian investors, such as David Dreman, highly successful manager of the Scudder-Dreman funds and author of Contrarian Investment Strategies. Dreman looks for value in distressed companies that few others want, such as Bank of America (NYSE:BAC) late in 2000 and Fannie Mae (NYSE:FNM) recently, when the stock dropped 30% in the wake of investigations of its accounting for derivatives.

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 fair value before I'll invest in a company. In my mind, not all companies or stocks are created equal. Of course, I want to buy Berkshire Hathaway at a 40% discount, but I don't ever expect to see it trading that low in my lifetime. However, because 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: wounded elephants, cyclicals, former glamour stocks, fallen angels, bankruptcy survivors, and stealth stocks. I outlined these areas in more detail in Part 1 and Part 2 of "Hunting for Value."

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 a risk-free 30-day trial on me. If you are not 100% convinced that Inside Value will make you money, you won't pay a dime. Or, for a limited time, purchase Inside Value at a 25% discount. Now that's value. Either way, 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, until we chat again, I wish you good value investing. Oh, and Fred, try to stay away from those flyers.

This article was originally published on Nov. 5, 2004. It has been updated.

Philip Durell is the analyst for the Motley Fool Inside Value newsletter. He owns shares of Berkshire Hathaway. His wife owns shares of Fannie Mae. The Motley Fool is investors writing for investors . Fool disclosure rules are here.