Stocks on the Rise

It's easy -- and useful -- to follow the crowd at times. Folks follow trends in fashion (what's in for spring?) and 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'd like never 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 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 find great companies that 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 78% (or 15% 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 in 2005 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 bought Baidu contrary to the crowd, you could have gotten in at the low price and held for a 163% 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 19.8%. 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- and dividend-adjusted high of $37 per share in 1998 to $14 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, 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, remember that even the greatest of great companies -- Dell and 3M, to name two recent examples -- can fall out of favor at times. When Dell lowered its growth estimates and when Intel (NASDAQ:INTC), the provider of Dell's microprocessors, lowered its outlook and missed estimates, investors shied away from both of these companies. When 3M lost its CEO to Boeing (NYSE:BA) 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 contrary strategy has put his service almost 7 percentage points ahead of the market, and several of his recommendations are still trading at what he considers to be bargain prices. To find out what they are, click here and 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 first published April 17, 2006. It has been updated.

Motley Fool sector head Shruti Basavaraj does not own shares of any company mentioned above. Baidu is a Motley Fool Rule Breakers choice. Dell, 3M, and Intel are Inside Value picks.Dell is also a Motley Fool Stock Advisor selection. The Fool'sdisclosure policyis sealed for freshness.