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% 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. They buy deeply undervalued stocks, such as those trading at or below book value or those trading at a big "margin of safety" (e.g. at a discount of at least 50% to their estimation of the stock's true worth). These are the "deep value" guys, and when the stock approaches fair value, they sell and repeat the process with another stock. When I started Inside Value, my very first pick, MCI (NASDAQ:MCIP), fell into this category. Others are more like Warren Buffett and Charlie Munger at Berkshire Hathaway (NYSE:BRKa). That is, they still look for big margins of safety, but they are prepared to pay up for companies that truly display long-term competitive advantages. These are companies such as Proctor & Gamble (NYSE:PG), Anheuser-Busch (NYSE:BUD), and ExxonMobil (NYSE:XOM).

Then there are others who follow the path less traveled and are true contrarian investors, such as David Dreman, the 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 ConocoPhillips (NYSE:COP) in 2003 and Altria (NYSE:MO) in the same year, when the stock dropped below $30 on fears of massive litigation awards.

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 stock 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, subscribe to Inside Value and receive The Motley Fool's Blue-Chip Report 2005:10 Monster Stocks for the Next Decade-- for free. 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 stocks on my current Watch List. Right now, you can also enter to win our competition "A Stock I'd Love to Own." The top prize is a one-year subscription to Inside Value. Click here to begin your free trial.

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 advisor for the Motley Fool Inside Value newsletter. He owns shares of Berkshire Hathaway. His wife owns shares of Fannie Mae. Anheuser-Busch is one of Philip's Inside Value recommendations. Fool disclosure rules arehere.