Stocks on the Rise

It's easy -- and useful -- to follow the crowd at times. Folks follow trends in fashion (what's in for fall?) and electronic gadgets (another iPod, anyone?), for instance. 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'd like never to repeat.

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 to push these dollars up the hill -- it's called "relative strength." 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 involves using financial metrics to determine what companies are great and have potential for long-lasting returns. But the important thing is to wait for the rainy day when the market panics -- and buy the stock at a discount to its intrinsic value.

Consider a few examples:

Case in point No. 1: The aforementioned tech bubble.

In 1999 and 2000, Electronic Data Systems (NYSE:EDS) was the next big thing -- along with Oracle (NASDAQ:ORCL), Qualcomm (NASDAQ:QCOM), and Buyjunknow.com. As investors who played the momentum game at that time 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 three companies from the end of 2002 is more than 81% (or 17% annualized). That's a lot of incentive to be contrarian when the masses are screaming "Buy!" or "Sell!"

Case in point No. 2: Overanalyzed and overhyped IPOs.

For a more recent example, take a look at Baidu.com (NASDAQ:BIDU). It IPO'd late last year at $27 a share, shot up to $122.54 a share purely on momentum, and then plummeted to $44 a share. 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 91% gain.

Case in point No. 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 split-adjusted high of $37.86 a share in 1998 to $14.53 less than two years later. 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. It's where you find a great company and simply wait for it to go on sale.

If you think this can't happen, realize that even the greatest of great companies -- Dell (NASDAQ:DELL) and 3M (NYSE:MMM), to name two recent examples -- fall out of favor at times. When Dell lowered its growth estimates earlier this year, and when Intel (NASDAQ:INTC), the provider of many of Dell's microprocessors, lowered its outlook and missed estimates, investors shied away from both of these companies. When 3M lost its old CEO and went on to lower revenue-growth guidance, the market perceived this as stagnation amid slow product offerings and lack of innovation. But when the company decided to reorganize its businesses and focus on its core competencies, profit growth increased significantly, and the stock suddenly 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. This contrarian strategy has put his service almost four percentage points ahead of the market, and 17 of his recommendations, including Dell and 3M, are still trading at what he considers to be bargain prices. To find out what the other 15 are, click here to be Philip's guest at the service free for 30 days.

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

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

Shruti Basavaraj owns no shares of any company mentioned above. Dell is a Stock Advisor and Inside Value recommendation. 3M and Intel are Inside Value picks. The Fool's disclosure policy is sealed for freshness.