The Beginner's Guide to Crushing the Market

Whole Foods Market (NASDAQ:WFMI) recently announced that its earnings for its 2006 fiscal year had jumped 49.5% compared with the previous year, on revenues that had risen 19%. That's a respectable performance for any company, especially for one whose sales measure in the billions.

Yet upon releasing the news, Whole Foods' shares plummeted 23% in a single day. All told, in fact, its stock has declined some 40% this year. Part of the reason for the most recent fall from grace was that the company dialed back its growth projections for 2007. Most of it, though, was because the market had expected and priced in even faster growth and better things to come.

That's the primary peril you face when you invest in high-priced, fast-growing companies. Eventually, growth slows. When that happens, it destroys the wild-eyed hope that had sustained a former glory stock's price, and it takes investors' wealth down with it.

Control the carnage
While nobody could have predicted exactly when Whole Foods' story would begin to unravel, at least one fellow Fool, Tim Beyers, predicted that it would. His concluding passage summed up the problem quite nicely, nearly eight months before the crash:

Whole Foods is a wonderful company with a wonderful culture and a necessary set of products. But there's a fair price to every business. For Whole Foods, three times its long-term expected growth rate is anything but fair.

In other words, if a company's shares are too expensive, you will very likely lose money. That holds true no matter how great the business behind the stock may be. If you want to avoid getting trapped by the next growth story gone soft, you've got to understand a company's value.

By focusing on a company's true worth and letting that drive your investing decisions, you can absolutely crush the market over time. Legions of investors have done so, following the value investing strategy first pioneered by the legendary Benjamin Graham.

How it works
Value investing is based on the straightforward premise that stocks are worth something. Specifically, what they're really worth is based on an educated and realistic estimate of the underlying company's long-term earnings potential.

Do we know exactly what that number is? Heck no. Nobody does. But we can get close. And as Warren Buffett -- the most successful value investor of our era -- has said, "It is better to be approximately right than precisely wrong."

To be successful at value investing, all you really need to do is learn to recognize when the market price for a company is way out of whack with its earning potential. Once you find a business that's worth well more than its stock price indicates, you simply buy the stock and wait for the market to correct its mistake.

Why it works
Value investing works because in the heat of the moment, many investors lose sight of what they're really buying in the stock market: small pieces of businesses. If all you see are a bunch of pixels on a screen with dollar figures attached, it becomes easy to forget the company behind the stock.

Without that link between the stock and its company, you may be tempted to believe that you're losing money whenever a stock drops. Naturally, if you're losing money, your first inclination is to stop doing whatever it is you were doing. In other words, you may want to sell the stock, cut your losses, and move on to greener pastures.

On the contrary, when a stock drops, something entirely different happens. What really takes place is that you get the opportunity to buy more of a business for less money. That link between the stock and its underlying company is crucial to remember if you want to keep your wits about you and profit from panic.

Focus, focus, focus
Eventually, though, saner heads prevail, and stocks seek out their true values. Yet as the chart below shows, your returns in the past year could have varied wildly depending on what decisions you made and when you made them:

That last column is critical to your understanding of why the value philosophy wins. Depending on how much you were willing to pay for each company's future earnings, your returns would have varied wildly. In each case listed here, there was at least a 40-percentage-point swing between the lowest possible return and the highest, all within the past year.

The best way to end up closer to the high end of the returns is to stay focused on the true value of the companies behind the stocks. That way, you can more easily tell when you're getting a sale price and it's time to buy or when you're being made an offer you can't refuse and it's time to sell.

Simple, effective, profitable
When you follow the value investing strategy, all you concern yourself with is what a company is really worth. That information tells you when to buy and when to sell. For generations, value investors have followed that straightforward strategy to end up well ahead of the pack. At Motley Fool Inside Value, we find this investing approach incredibly appealing in its simplicity and potential, and we have used it to outperform the market since our 2004 launch.

It doesn't take a rocket scientist or a fortune teller to beat the market. All it takes is a willingness to accept the value premise -- that stocks are actually worth something and that you can estimate what they're worth. To find out what some of the biggest companies around are really worth, take the next 30 days to try Inside Value for free. You have nothing to lose but your time. Click here to get started.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Fair Isaac. Dell is an Inside Value pick. Whole Foods and Dell are Stock Advisor recommendations. The Fool has a disclosure policy.