Investing's Afterburner

If you've ever even considered investing your hard-earned dollars, you've probably heard statistics indicating that the stock market has historically returned 10% to 11% per year, on average, over long periods of time. You may have even seen charts showing how you could potentially turn $1,000 into $100,000 over time, just by investing in the market. And it's absolutely true: With enough time to let your money grow, investing in the stock market can reward you quite nicely.

If you've looked carefully at those charts, though, you'll notice something important: Most of that money is made years from now, way down the road. At 10% per year, it'll take you just about 49 years -- almost half a century -- to turn that $1,000 into $100,000. Take a look:

Notice how most of your money is made near the end; you make more between years 40 and 49 than you do in the first 39 years combined! That's just how compounding works -- you need money to make money, and there's very little we can do about that.

Kick it up a notch
There is a way to jump-start your returns, though -- a way to get an extra boost of performance that'll help you reach that "$1,000 into $100,000" goal much, much faster. And that's through the power of value investing. Value investing acts much like the afterburner on a high-powered jet aircraft -- it gives you that extra kick of speed to accelerate the process of compounding your money.

Here's how it works: Every stock has a fair value -- a market price that exactly matches what the company behind that stock is worth. Most of the time, that fair value is reflected in the market price of the stock. But every once in a while -- maybe because of a management shakeup due to shady accounting practices, as occurred to Tyco (NYSE:TYC) in 2002, or perhaps because an insurance company like Allstate (NYSE:ALL) might just be facing an abnormally expensive hurricane season right about now -- the market will underprice great companies. That's when value investors turn on their afterburners and snatch superior firms at a discount to their worth. After all, value investing is the only proven afterburner in the market. If you don't believe me, just take a look at how master investors Tom Knapp and Ed Anderson helped make Tweedy, Browne one of Wall Street's most venerable market-beaters, or how our own Fool Philip Durell is beating the market in his Motley Fool Inside Value newsletter service (I'll back that up with hard numbers later).

The afterburner secret
A company trading well below its fair value has what value investors call a "margin of safety" -- a substantial gap between what the market says it is worth and what its financial statements and realistic projections really show it to be worth. The margin of safety makes for extra gains and is the secret to value investing.

Think it can't happen? Consider that a single share in billionaire value investor Warren Buffett's Berkshire Hathaway could be bought for $67 a stub in October 1976. Less than 29 years later, that same share recently changed hands for $82,990 -- a compound return of just about 28% per year. Buffett achieved his results thanks to the value-investing afterburner. He bought shares in iconic brands such as tax and financial services provider H&R Block (NYSE:HRB) and media giant Washington Post (NYSE:WPO) when the market thought they had lost their way and priced them down. Buffett is known for buying great businesses at low prices, then holding forever -- his relationship with the Washington Post began when he started delivering papers for the company in 1945.

Our goal as investors is to speed up the 49-year process of turning $1,000 into $100,000. By finding undervalued companies and letting the value afterburner boost them up to fair value over time, you can cut years off that journey. While perhaps no one can match the great Oracle from Omaha, if you can become a bit more than one-third the value investor that Buffett is, value investing will put you 20 years closer to your goal. Factoring in 16.5% annual returns -- outperforming the market by 5.5% to 6.5% vs. Buffett's 17% to 18% outperformance -- your returns are significantly boosted:

The other afterburner secret
This is the obvious one, but it's worth mentioning: Always avoid overvalued stocks, despite tidbits that look good in a 10-K, such as rising earnings, growing profits, or great year-over-year whatever. Consider Internet pioneer Sun Microsystems (NASDAQ:SUNW), which traded as high as $64.31 per stub at the height of the tech bubble. During the four quarters prior to that peak, Sun had earned all of $0.59 per share, which meant that it traded at an astounding 109 times its trailing earnings. Fast-forward to the present day. The shares of Sun that traded as high as $64.31 a few years back now fetch approximately $3.82. Plain and simple, Sun stock was overvalued.

Show me the money
To get the full afterburner effect, follow this basic strategy: Find companies trading below their fair values, buy them, and wait for the market to reward you handsomely. I told you earlier that Philip Durell is beating the market. His Inside Value newsletter has returned 11.61% to subscribers, vs. just 4.51% for the S&P 500. That's an outperformance of 7.1 percentage points in just over a year. With that kind of performance, your $1,000 could be $100,000 a lot faster than you think.

If you're interested in becoming a subscriber, consider a 30-day free trial to Inside Value. Philip's afterburner advantage has come from companies such as beverage giants Coca-Cola (NYSE:KO) and Anheuser-Busch (NYSE:BUD), the latter of which Philip first uncovered for subscribers shortly before Buffett himself did for Berkshire. While their names and business lines may elicit yawns from those more interested in following the latest fad, there's certainly nothing boring about their market-beating returns for subscribers. Click here to learn more.

This article was originally published on Aug. 8, 2005. It has been updated.

At the time of publication, Fool contributor and Inside Value team memberChuck Salettahad no financial position in any of the companies mentioned in this article. The Fool isinvestors writing for investors.