The 3 Keys to Beating the Market

There are three critical items you absolutely must have if you want to make serious money in the stock market. Without all three firmly in place, you risk waging a losing battle. With all of them on your side, however, even if you start from modest means, you just might end up a millionaire.

Fortunately, these three essentials are so commonplace that virtually anyone can make use of them. To be successful, you just need to know what they are and how to use them to your advantage. What are they?

Time, cash, and a rational investment strategy.

Time
Quite simply, the more time your money has to grow, the bigger the effect that compounding has on your returns. Compounding happens when the returns on the money you've invested start earning returns of their own. It's how serious wealth is earned, and its effect simply gets larger the longer your money is invested.

To illustrate the raw power of compounding, here's a chart showing what happens to $1 invested at 10% annual returns, with the 10% looked at two different ways. The first return is based on "simple interest," where only the original investment gets a return. The second is based on "compound interest," where the returns include the effect of the new money generated by the already invested money.

As you can see, the effect of compounding can be staggering over long periods of time. After 30 years, you could end up with more than four times as much money, thanks simply to the benefits of reinvested returns.

Cash
No matter how much we'd like to believe otherwise, you simply have to have money before that money can earn money. The good news, though, is that you don't need to start out with a fortune in order to end up with one. A one-time $4,000 investment can turn into nearly $70,000 in 30 years, if it earns the market's historical return of around 10% per year. Even better, if you invest just that much at that return every year for the next 30 years, the net result can be astounding. As this chart shows, you can end up with considerably more than $700,000 for your troubles.

So why pick $4,000? Two reasons, really. First, that's the current limit on IRA contributions for many of us out there trying to earn a living. Second, looked at on a daily basis, it's a shade less than $11 a day. That's a number within most of our reaches, as long as we put our minds to it and make investing in our futures a priority. With nearly three-quarters of a million dollars waiting at the end of the tunnel, that's a small sacrifice for a tremendous potential gain.

A rational strategy
Time and cash will get you far, but what will really put you over the top is a top-notch investing strategy -- one with a legitimate potential to actually beat the market over time. You don't have to beat the market by much to make a significant difference over time. If the market's long-run return rate is about 10%, and you can beat it by just two percentage points through shrewd stock-picking, at the end of 30 years, you just might end up a millionaire. Take that same $4,000 annual investment, and bump up the return just a bit:

At Motley Fool Inside Value, we follow the time-tested market-beating strategy pioneered by Benjamin Graham and perfected by his students such as Warren Buffett. We find companies that trade for less than they're really worth, buy them on the cheap, and then wait for the market to realize its mistakes and bid the businesses up to a more reasonable level.

Just as it has for generations of investors before us, value investing still beats the market today. The Inside Value returns may be "merely" a few points ahead of the market, but so what? As that above chart shows, a consistent lead of just a few percent can add up to a tremendous amount of cash in the long run.

Get started now
If you want to follow in the footsteps of Buffett and Graham, your first step is to find value-priced companies. An easy way to look is to screen for potential values. One of my favorite value screens looks for companies that:

• Have stronger operating cash flows than their reported earnings
• Pay regular dividends that have risen in the past few years
• Reinvest a decent portion of their cash in their own expansion
• Are expected to have some growth in the future.

Companies that currently meet those criteria include:

Unfortunately, screening data only gives you a starting point. What a screen can't tell you is whether it's really a value or a value trap -- a company that looks deceptively cheap but really isn't.

Exploit our experience
That's the real advantage of Inside Value. Anyone can build and run a screen to find companies that look cheap. It takes significant experience and understanding of the overall business environment to decide if an apparent discount is for real or if it's too good to be true. For instance, as an oil company, Sunoco is heavily dependent on the price of that volatile commodity. The stock only looks cheap now because oil is not. Likewise, LandAmerica's business is dependent on the housing market. While its long-term prospects look solid, a deflating bubble increases the potential of short-term pain.

Of the companies on that list, only Home Depot has made the final cut as an official Inside Value pick. To find out why it passed, take a 30-day free trial here, then click here to go the recommendation.

With time, cash, and the rational Inside Value strategy on your side, you, too, can become a successful investor.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta had no direct ownership of any of the companies mentioned in this article. The Fool has a disclosure policy.