Stocks on the Rise

It's easy -- and useful -- to follow the crowd at times, whether you're tracking trends in fashion (what's in for fall?) or electronic gadgets. (Another iPod, anyone?) But following the crowd as an investing strategy? That's an entirely different story, and for those of us who had huge losses in the post-2000 Nasdaq crash, it's one we never want to repeat again.

Sure, if you get in early enough, you can make some big short-term gains following what's commonly called momentum investing. There's even a pretty savvy measure you can use, called "relative strength," to push these dollars up the hill. But for most of us, that's a recipe for buy-high-sell-low disaster.

Take advantage of the herd
A little thing called value investing -- preached by a few luminaries you may have heard of (Graham, Buffett) -- can help you buck such a herd mentality. Value investing uses financial metrics to discover great companies with the potential for long-lasting returns. But it works only if you wait for the rainy day when the market panics -- and buy the stock at a discount to its intrinsic value.

Consider a few examples:

1. The aforementioned tech bubble
In 1999 and 2000, NVE was the next big thing -- along with EMC, CNET, AMD, and Buyjunknow.com. As investors who played the momentum game back then now know, following the train (wreck) can lose you some hefty stacks of cash.

But if you'd recognized the worth of these companies and their business models while the market was reacting to the crash, you could have found some real value -- the average gain for these four companies from the end of 2002 is more than 150%. That's a lot of incentive to be contrarian when the masses are screaming "Buy!" or "Sell!"

2. Overanalyzed and overhyped IPOs
For a more recent example, take a look at Baidu.com. It IPO'd late last year at $27 a share, shot up to $122.54 purely on momentum, and then plummeted to $44. If you'd followed the momentum crowd, you would have lost a significant amount of money when you sold on the weakness. But if you chose Baidu as a value play, you could have bought into it at the low price and held it for a 63% gain.

3. Great business, short-term worry
According to Jeremy Siegel's The Future for Investors, the best-performing stock in the entire S&P 500 since its inception has been Altria, with an annualized return of 19.75%. But even this mammoth performer had its ups and downs when the momentum crowd was changing its mind -- the company's stock price was halved from a 1998 split-adjusted high of $37.86 to $14.53, all in fewer than two years. And with worries of never-ending lawsuits abounding in the market, it traded in this range until 2003. This is a prime example of a value play -- if you had the knowledge and courage to invest in a great company when the rest of the market was overreacting to a negative outlook, you would be very happy with your returns today.

Up and down, and back around
Value investing can help you beat the momentum crowd by finding a great company and simply waiting for it to go on sale.

Even the greatest of great companies fall out of favor at times. Take Intuit and Coca-Cola, to name two recent examples. When the market overreacted to fears about Intuit's competitive position, as competitors such as Microsoft (NASDAQ:MSFT) angled for a piece of its business, the company's stock plummeted to less than $40 a share. But once people realized that the company was firmly gaining ground with its accounting and tax-preparation software, the stock rebounded. It's currently amassed a nice gain from that low. When Coca-Cola seemed to be stagnating and suffering from competition with PepsiCo (NYSE:PEP), the market overlooked Coke's phenomenal brand value, estimated to be worth $67 billion. But once the market saw that the company's massive distribution network was helping it conquer worldwide markets, the stock came back into favor.

Motley Fool Inside Value analyst Philip Durell waits for exactly these opportunities. He creates a wish list of stocks and waits to pay the right price. He did this with Intuit, earning subscribers of the newsletter 61% in gains. This contrary strategy has put his service ahead of the market, and 28 of his recommendations, including Coca-Cola, are still trading at what he considers to be bargain prices. In fact, today is the day that two brand-new picks are revealed, and Philip believes that both are undervalued by at least 20%. To find out what all of Philip's exciting picks are, be his guest at the service free for 30 days.

Everyone wants a piece of a stock on the rise. By being a value investor, you can find stocks before they soar.

This article was originally published on April 17, 2006. It has been updated.

Fool financial editor Shruti Basavaraj owns shares of Microsoft. Intuit, Microsoft, and Coca-Cola are Motley Fool Inside Value picks. CNET is a Rule Breakers pick. The Fool'sdisclosure policyis sealed for freshness.