Value and the 10-Bagger

We've all heard the stories of how you can make a fortune in the stock market simply by finding the nextStarbucks (NASDAQ:SBUX) or the nextMicrosoft (NASDAQ:MSFT), before they hit it big. It's a great theory, but it has one major problem. It's pretty simple to identify Microsoft and Starbucks as having been superior investments today, but it was nearly impossible to do so back when you could have made outrageous investing profits.

The dangers of the future
An attempt to go looking for the next Starbucks, for instance, could very well have handed you KrispyKreme Doughnuts (NYSE:KKD). Instead of being the success story everyone anticipated, its aggressive expansion plans led to significant overcapacity and a nearly fatal financial collapse. Without perfect hindsight, could you really have known that Krispy Kreme would have fallen apart -- and in time to take your money off the table?

Even if you did manage to avoid being suckered in by the potential for a pretender to become "the next big thing," the path to investing profit is still not clear. Assume you found Microsoft early. Would you have had the stomach to hold on through its meteoric ascent, even though its shares almost never looked cheap or fairly valued on the way up? Remember the context of the times. Apple (NASDAQ:AAPL) was the undisputed leader of the graphical computer interface. IBM (NYSE:IBM) was still a personal computing powerhouse. The late 1980s release of OS/2 was a clear threat to the then small Microsoft and the DOS/Windows products that would fuel its fortunes.

Microsoft's path to greatness was never crystal clear to the outside world, until it was too late to profit from it. The fact that the Microsoft Billionaires Club consists largely of the company's founders and early employees shows how difficult it was to successfully make that call. If you weren't tied to the company and its stock, there was no way you were going to see those stellar returns.

How to really profit
Fortunately, there is a way to make those market-trouncing returns without the benefit of perfect foresight and a crystal ball. It's called value investing.

To illustrate the amazing profit potential available with the value strategy, here's an illustration of how $1,000 could have been turned into $10,000, in less than three years. Yes, that's a bona fide, value-based 10-bagger. It involves actual dates, companies, and share prices involved in my real-world transactions. Only the dollar amounts have been changed, to protect my financial privacy.

That's a 10-bagger from two stocks and one strategy. I didn't catch the absolute low on the buy side of either stock, nor did I sell either one at precisely the top. In MGP Ingredients' case, in fact, the ethanol frenzy continued to lift its shares to about $36 before they began settling back down to earth. What I did do, however, was find solid a company trading dramatically below what its business was worth. I bought, and then I held on until I could no longer justify its valuation. Then I sold, plowing the proceeds into another company displaying similar value-based characteristics. And as before, that company left my portfolio when its share price could no longer be justified by its deliverable operating results.

It's an example of how to buy low and sell high, based on value investing criteria. All it took was the willingness to compare what the market was asking for the businesses with what their financials suggested they were worth.

How it was done
I looked for companies that:

• Were trading near or less than their book values;
• Paid dividends; and
• Had shown recent evidence of being willing to raise those dividends.

With the results of that screen in hand, I asked:

• Why is the stock so cheap?
• What are the biggest risks to the company's future?
• Will the business likely recover?

With satisfactory answers to those questions, the decision to buy was easy. On the flip side, when the stocks' valuations were no longer supported by delivered financial results, the need to sell was evident. There was no need to guess when the stocks would stop climbing and no need to worry whether the trend would be coming to an end.

Of course, not every opportunity turns out this well. For instance, I'm a partial owner of sinking automotive titan General Motors. Even though I thought I had a value on my hands, the company's operational issues went far deeper than I anticipated. That's the risk in buying stocks that have been knocked down -- they could stay down for a while.

The Foolish bottom line
Companies touted as the next big thing often aren't, and while value investing isn't a strategy without risks, it's a better way to better returns. It's also the strategy we use each and every month at Motley Fool Inside Value to dig up firms trading at dramatic discounts to their true worth. It's a strategy that has us nearly four percentage points ahead of the market. Click here to learn more and to start a 30-day free trial.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Microsoft and General Motors. Microsoft is an Inside Value recommendation. Starbucks is a Stock Advisor recommendation. The Fool has a disclosure policy.