Win the War With Wall Street

The grisly reality
It doesn't take too long for individual investors to find out the truth of running their own money. Investing is a war, and Wall Street's got you in the crosshairs. Even when the generals on Wall Street are working for you (such as when you, say, own professionally managed mutual funds), they're really working for themselves first -- so they can afford those Porsches and Italian suits. Just try getting a rebate from a fund that underperforms its benchmark -- as the majority do -- year after year. It's not going to happen.

And if the Wall Street big shots are working against you when they're working for you, just imagine what they're doing when they're really against you. I recently read an article in BusinessWeek about how banks are gearing up for big battles in the equities, commodities, and derivatives markets. They're hiring more math whizzes than Google, expanding their trading floors to tens of thousands of feet, and looking for any way to get an edge on each other, and on you.

The investing game is a prime new cash cow, and it's not just better-known trading outfits such as Goldman Sachs (NYSE:GS) or Merrill Lynch (NYSE:MER) looking to profit. It's the likes of Citigroup (NYSE:C), too.

If you consider the millions of dollars that banks and brokerages are investing and sticking you with the sharp end of the trade, you might figure, "There's no way I can win that battle."

The art of war
Congratulations -- you're on your way to winning the war. Because you're right: There is no way you'll win that battle. You can't compete with traders with that kind of hardware, so there's no point in trying.

But let's be clear: This does not mean that you don't invest.

What it does mean is that you pick your battles. And you do it carefully.

Ancient Chinese secret
This is one of the most important bits of advice from the world's oldest military treatise, Sun Tzu's The Art of War. "In war," Sun Tzu wrote, "the victorious strategist seeks battle only after the victory has been won."

To put it another way, "The victor seeks only battles that he knows he will win."

Of course, any investor -- like any general -- knows that you can't win them all, but you can win a lot more battles when you fight the right ones.

Choose a battle with your terms
In investing, the real battle is always over what you pay. It's not a business' health, assets, or growth that determines your returns; it's what you pay for them that matters. Whoever consistently pays the least, wins.

One good illustration of this is the historical rate of return on cheap stocks versus expensive stocks. A handy summary in Investment Fables by noted finance and valuation expert (and Fool contributor) Aswath Damodaran shows that low-P/E stocks trounce high-P/E stocks. From 1952 to 2001, the stocks with the highest P/E ratios returned 11% annually, while low-P/E clunkers put up 21% annually. That first figure, by the way, is approximately what you could get simply investing in a broad market index, like the S&P 500.

The spoils of war
The past can't predict the future, but just for fun, lets take a look at what it would mean for a portfolio if you began with $10,000, invested only $4,000 more per year, and managed the returns cited in those examples.

I don't know what kind of change you've got in your couch cushions, but $958,000 sounds like a lot of cash to me.

Of course, I'm not so sure any of us is going to put up 21% annual returns, but even a smidgen of outperformance can add up to a lot. Take a look at what you'd book over the same two decades if you took just two points more than those high-P/E returns.

Not quite as impressive, but if you don't want the extra $100K, go ahead and send it my way -- my email address is at the bottom of this piece.

Of course, just running out and buying stocks with a low P/E ratio isn't a foolproof way to run your portfolio. Many companies reach this point because they are, in fact, broken. But a low P/E is often a very good starting point for further research.

Fine-tuning your tactics
When you pay less than what you know (or strongly suspect) a company is worth, you win more battles with Wall Street.

Here are three big names that have been the subject of Street battles over the past few weeks and months. While Wall Street traders try to outmaneuver each other for small gains, clever generals like us should concentrate on the fact that these three companies have strong consumer franchises and good growth prospects -- including in some expanding foreign markets. In other words, they have proved that they have what it takes to succeed over the long term.

You may also notice that, by historical standards as well as my rough cash-flow valuations, they seem to offer some compelling deals.

Foolish final word
This is the approach I follow for the vast majority of my investing, and it's paid off particularly well during market swoons. (Turns out that picking your battles this way is an excellent defensive strategy as well: Good companies that have already been beaten up don't take much more damage when malaise settles across the entire market.)

Picking battles carefully happens to be the entire strategy my colleagues use at Motley Fool Inside Value. They choose stocks based on reasonable -- or better yet, conservative -- assumptions about their future cash flows, assets, and competitive position, and only when they're trading at a good discount, meaning they carry a "margin of safety" to that estimated value.

In fact, 3M caught Inside Value guru Philip Durell's eye about the same time I latched on, and the recent earnings warning notwithstanding, it still looks like a strong pick to me. If you'd like to learn more about winning the war with Wall Street, a free trial of Inside Value will let you take a deeper look at how our community of value warriors goes about choosing the battles where victory is likely or assured. And if you join today, you'll enjoy immediate to access to today's brand-new issue -- and two newest value recommendations.

Seth Jayson spends too much time on virtual ancient battle strategy, as his mouse hand can attest. At the time of publication, he had shares of Johnson & Johnson and 3M but no positions in any other company mentioned. View his stock holdings and Fool profile here. J&J is a Motley Fool Income Investor recommendation. Fool rules are here.