Trounce the Market Over Time

As an investor, you have a fundamental choice to make. You can either buy low-cost index funds to match the market's returns, or you can try to beat them. Sustainably beating the market is no small task. After all, the vast majority of professional money managers fail to do it after factoring in the total costs of their services.

If you can manage to consistently outperform the market by just a little bit for a long time, though, the results to your pocketbook can be outstanding. Even 3 percentage points per year can add up over decades to a phenomenal advantage.

At this point, you might be thinking, "3 percentage points? What planet is this Fool from? Why should I bother doing all that extra work for a lousy 3 percentage points?" And, in a sense, you'd be right. After all, $10,000 is a sizable amount for most of us to consider investing. On a $10,000 investment, beating the market by 3% for a year would net you a mere extra $300. That hardly seems worth your effort.

Compound it
If you were only investing for the next year, you'd be absolutely right to question the value of a small advantage. If, on the other hand, you have a bit longer time frame, the difference on that initial $10,000 starts to get interesting:

That's a better than $67,000 difference. Not bad for a lousy 3-percentage-point advantage, eh?

Of course, most of us aren't in the position to make a gigantic one-time investment and have it alone bring us our financial independence. Even that pretty substantial $10,000 investment by itself isn't really going to grow enough to dramatically change our lives. Make that size of an investment every year, however, and keep a sustained 3-percentage-point edge, and your long-term advantage becomes crystal-clear:

At the end of 25 years with a sustained 3-percentage-point edge, you end up with a nearly half-million extra dollars in your pocket. Now, we're talking life-changing, eye-popping sums of money, courtesy of the same small edge that handed you an extra $300 in the first year. Does it sound interesting yet?

Make it work
The catch, of course, is that very few people have managed to keep an edge over the market for very long, much less for a quarter-century. Those who do have by and large had one thing in common: The greatest investors have been value investors.

Perhaps you've heard of a man called Warren Buffett? Or his business partner, Charles Munger? Then there are the other Superinvestors of Graham and Doddsville, Walter Schloss, Bill Ruane, Stan Perlmeter, Tom Knapp, and Ed Anderson. And let's not forget the men who started it all, Benjamin Graham and David Dodd. All of them are long-term, market-trouncing value investors.

The specific methods each employed may have been different, but all the Superinvestors shared a common core philosophy:

• When you buy stock, you're really buying a small part of a business.
• There's a difference between the value of a business and the price of its stock.
• The less you pay with respect to that value, the better your returns will be.

For more than half a century, value investors have followed this philosophy and succeeded where nearly everyone else has failed. As our market-topping performance at Motley Fool Inside Value shows, the value strategy that has served investors so well still winds up ahead today.

Why it works
The key to success as a value investor is twofold. First, you must identify when a company looks legitimately cheap, and second, you must be willing to buy it once you recognize it. As the table below shows, though, that's often easier said than done:

These companies were all legitimate bargains, but the reasons they were cheap had to do with clear and obvious problems in their operations. Real values often appear to be damaged goods.

In fact, that's precisely why they're values. When a company slips up, as all companies inevitably do from time to time, the stock market views it as riskier. The higher the apparent risk, the lower the price a rational investor is willing to pay. Yet the lower the price, the better the chance that the stock will trade below the company's true worth.

What's next?
Lessons from the past are nice, but they're largely useless unless you can convert them into profits for your future. The companies profiled here have recovered and are no longer the absolute bargains they once were, but the next value is out there. It's waiting to be found by enterprising investors who are willing to look beyond a weak stock price in order to invest in a far more solid company.

We look for it every day in Inside Value. To join us in the search and to see the values we believe are lurking on the market today, join us for a free 30-day trial. If you truly master and apply the value philosophy, the next Superinvestor just may be you.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Motors, Microsoft, and Merck. Microsoft is an Inside Value selection. Merck is a former Income Investor recommendation. The Fool has a disclosure policy.