The simple truth is that we're all only human. Not a single one of us has any superpowers. We can't leap over tall buildings in a single bound. We're not faster than speeding bullets, or even the stock market for that matter. And we certainly cannot predict the future with any certainty. With our merely mortal abilities, however, we can do something that many academics view as impossible. We, individual investors, can beat the stock market over time.
The secret to investing success is to play to our strengths, the inherent advantages that we have over the major institutions that dominate the market. It doesn't take rocket science. All it takes is a rational, value-focused investment strategy -- a time-tested approach pioneered by Benjamin Graham more than half a century ago and perfected by his star pupil Warren Buffett in recent years. It's by traveling this well-worn, reliable, and still fruitful path that my friend and colleague Philip Durell has been able to beat the market by six percentage points over the life of his Motley Fool Inside Value newsletter.
Wall Street's Kryptonite
The largest and most powerful advantage we have over the market, the one that's nearly universally fatal for institutional investors, is really quite simple. It's time. The clock is always racing for the big guys. If a fund like Fidelity Magellan (FUND:FMAGX) reports one quarter or one year where it underperforms its competition, it faces the wrath of its investors, who often will go so far as to pull money out of a falling fund to invest in supposedly greener pastures elsewhere. Pulling money out of a fund tends to exacerbate any problems in that fund. Investor redemptions lead to share sales, which put downward pressure on the stocks the fund owns, which further decreases performance. It's a vicious cycle. In Magellan's case, such problems mean that what was once the largest mutual fund out there has lost that throne to the Vanguard 500 Index (FUND:VFINX).
Yet we individual investors don't face the same time crunch. In fact, we can use time to our advantage, drawing our strength from the very element that harms the big guys. We have two weapons, which if we deploy properly, will put time on our side and help us slaughter the market.
What's it worth?
The first weapon we can use against the market is valuation. When funds get stuck in the vicious cycle of redemptions and stock sales, they're often forced to unload companies without regard to what those firms are really worth. It's a well-known phenomenon referred to as "throwing the baby out with the bathwater," and it's one trait endemic on Wall Street that we can use to our advantage.
Earlier this year, in fact, I took advantage of such an opportunity to buy specialty grains and alcohol distiller MGP Ingredients (NASDAQ:MGPI). The end of the Atkins fad meant a slump in the company's low-carbohydrate food business, taking down the company's formerly high-flying stock. In spite of that slump, the company is still profitable, and still has a value. When I found the company in February, it traded well below that value, and I've been rewarded with a better-than-21% gain in a period when the S&P 500 has gone virtually nowhere, eking out a gain of merely 0.007%.
Learn from the masters
Just as Warren Buffett learned this method from the expert teachings of Benjamin Graham, I've studied it under the tutoring of Inside Value's Philip Durell. His mastery of the technique allowed him to uncover for subscribers the value hidden in title insurer First American (NYSE:FAF). At the time of his discovery, fears of rising interest rates were slamming all sorts of housing-related stocks, including title insurers, builders like Toll Brothers (NYSE:TOL), and big mortgage banks such as Washington Mutual (NYSE:WM). Since he recommended First American just over a year ago, it has leapt more than 50% as the much feared end of the housing boom simply failed to materialize. With returns like that, who needs Superman?
We value investors get valuation to work as a weapon for us through a tool known as a discounted cash flow calculator. With it, we can input a few facts about a company and our projections for the future of its business. The calculator then spits out a number that roughly represents the intrinsic value -- the true worth -- of the enterprise. If the company is trading significantly below that number, we can buy it and simply wait for the market to catch up. Inside Value has just such a calculator, available here for members. If you aren't already on board, click here to start your free 30-day trial and use our calculator to your heart's content.
When will it get there?
Of course, if valuation skills were all it took to be a decent investor, then the market would be always efficient, and Warren Buffett, by his own admission, would be "a bum on the street with a tin cup." The way we individual investors can really beat the market is by bundling our valuation tools with the one antidote for the Kryptonite effect that time has on Wall Street. Our second weapon is simple, good old-fashioned patience.
Since we lack superpowers and cannot predict the future, we simply do not know exactly when an undervalued company's stock price will rise to reach or pass its true worth. All we know is that eventually, a firm's price and its true value will cross. Without Superman's speed, we'll never be faster than the stock market, but with patience on our side, we can simply wait for the market to realize its mistake and catch up.
Within a few weeks after Philip selected pharmaceutical services provider Omnicare (NYSE:OCR) for Inside Value, for example, it dropped nearly 9% from what Philip convincingly labeled as a value price. An impatient investor could easily have sold at the low, fearing that the problems surrounding the company's planned acquisition of rival NeighborCare and its heavy reliance on Medicaid payments from cash-strapped states would plague the company for eternity. With the passing of time, however, the uncertainty cleared up, and that short-term loss was dramatically reversed. The stock is now up an astonishing 90% for Inside Value members in just under a year, and our patience has been justly rewarded.
The Foolish bottom line
With the powerful combination of valuation and patience in our arsenal, we mere mortals have the weapons it takes to beat the market without Superman's help. The market-trouncing value techniques pioneered by Benjamin Graham decades ago still work for individual investors today. Click here to start your risk-free trial to Inside Value and join modern master Philip Durell on his quest to conquer Wall Street with value.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares of MGP Ingredients and Omnicare. The Motley Fool has adisclosure policy.
